OCR A Level

Macro Economics

 
 
Copyright:  Tejvan  Pettinger,  Economicshelp.org  1st  August  2015    

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Table  of  Contents  
Economic  growth  ........................................................................................................................  4  
Macro-­‐economic  objectives  of  government  .................................................................................  5  
Recessions  ..................................................................................................................................................  6  
Economic  development  ............................................................................................................  7  
Measuring  development  .......................................................................................................................  7  
Sustainable  development  .....................................................................................................................  9  
Economic  growth  and  happiness  ...................................................................................................  11  
Circular  flow  of  income  ..........................................................................................................  14  
Aggregate  demand  ...................................................................................................................  16  
Consumer  spending  (C)  ......................................................................................................................  17  
Investment  (I)  .........................................................................................................................................  17  
Government  expenditure  (G)  ...........................................................................................................  18  
Net  trade  (X-­‐M)  ......................................................................................................................................  19  
Accelerator  effect  ..................................................................................................................................  19  
Aggregate  supply  (AS)  ............................................................................................................  20  
Short-­‐run  aggregate  supply  SRAS  ..................................................................................................  20  
Long-­‐run  aggregate  supply  (LRAS)  ...............................................................................................  22  
Macroeconomic  equilibrium  ............................................................................................................  24  
Economic  growth  ......................................................................................................................  25  
Short-­‐run  economic  growth  .............................................................................................................  25  
Long-­‐run  economic  growth  ..............................................................................................................  27  
Economic  cycle  .......................................................................................................................................  28  
The  Multiplier  .........................................................................................................................................  29  
Output  gaps  ..............................................................................................................................................  33  
Trends  in  macroeconomic  indicators  ...............................................................................  35  
Unemployment  and  employment  .......................................................................................  38  
Measuring  unemployment  ................................................................................................................  38  
Causes  of  unemployment  ...................................................................................................................  40  
The  natural  rate  of  unemployment  ...............................................................................................  42  
Policies  to  reduce  unemployment  .................................................................................................  44  
The  Phillips  curve  ....................................................................................................................  45  
Inflation  and  deflation  ............................................................................................................  48  
Effects  and  costs  of  inflation  .............................................................................................................  50  
Problems  of  deflation  ..........................................................................................................................  51  
Causes  of  inflation  .................................................................................................................................  53  
Quantity  theory  of  money  ..................................................................................................................  55  
Income  distribution  and  welfare  ........................................................................................  57  
Problems  of  inequality  ........................................................................................................................  58  
Poverty  .......................................................................................................................................................  58  
Fiscal  policy  ................................................................................................................................  60  
Evaluation  of  fiscal  policy  ..................................................................................................................  61  
Levels  of  government  spending  ......................................................................................................  63  
Taxation  .....................................................................................................................................................  65  
Government  borrowing  .........................................................................................................  67  
The  National  Debt  .................................................................................................................................  70  
Monetary  policy  ........................................................................................................................  71  
Evaluation  of  monetary  policy  .........................................................................................................  73  
Quantitative  easing  ...............................................................................................................................  74  
Liquidity  trap  ..........................................................................................................................................  75  
Supply  side  policies  .................................................................................................................  76  
Market-­‐oriented  supply-­‐side  policies  ..........................................................................................  77  
Interventionist  supply-­‐side  policies  .............................................................................................  77  

2  
 
 Evaluation  of  supply-­‐side  policies  .................................................................................................  78  
Policy  conflicts  ........................................................................................................................................  79  
Approaches  to  macroeconomics  .........................................................................................  80  
Classical  approach  ................................................................................................................................  80  
Keynesian  approach  .............................................................................................................................  80  
Monetarist  approach  ...........................................................................................................................  80  
Globalisation  ..............................................................................................................................  82  
Characteristics  of  globalisation  .......................................................................................................  82  
Causes  of  globalisation  ........................................................................................................................  82  
Impact  of  globalisation  .......................................................................................................................  83  
Multinational  companies  ...................................................................................................................  85  
Impact  of  emerging  economies  on  UK  economy  .....................................................................  85  
Trade  ............................................................................................................................................  86  
Example  of  trade  ....................................................................................................................................  86  
Restrictions  on  free  trade  ..................................................................................................................  87  
Benefits  of  free  trade  ...........................................................................................................................  88  
Arguments  for  restricting  trade  ......................................................................................................  89  
International  competitiveness  ............................................................................................  89  
Measures  to  increase  competitiveness  ........................................................................................  90  
The  balance  of  payments  .......................................................................................................  91  
Current  account  .....................................................................................................................................  91  
Factors  that  cause  a  current  account  deficit  ..............................................................................  92  
Policies  to  reduce  a  balance  of  payments  deficit  .....................................................................  92  
Exchange  rates  ..........................................................................................................................  95  
Factors  that  influence  exchange  rates  ..........................................................................................  96  
Purchasing  power  parity  (PPP)  ......................................................................................................  96  
Advantages  of  fixed  exchange  rates  ..............................................................................................  97  
Disadvantages  of  fixed  exchange  rates  ........................................................................................  98  
Euro/  Monetary  union  ........................................................................................................................  98  
Appreciation  in  the  exchange  rate  .................................................................................................  99  
Evaluation  of  an  appreciation  ..........................................................................................................  99  
The  Marshall  Lerner  condition  .....................................................................................................  101  
Economic  integration  .......................................................................................................................  102  
The  financial  sector  ..............................................................................................................  103  
Interest  rates  ........................................................................................................................................  104  
Liquidity  preference  theory  ...........................................................................................................  104  
Loanable  funds  theory  .....................................................................................................................  105  
Role  of  financial  markets  ................................................................................................................  106  
Financial  sector  in  developing  economies  ...................................................................  108  
The  role  of  the  central  bank  ..............................................................................................  109  
Independent  central  bank  ..............................................................................................................  109  
Regulation  of  the  financial  system  ..................................................................................  110  
 
 
 
 
 
 

3  
 
 Economic  growth    
• GDP  (Gross  Domestic  Product)  measures  the  value  of  goods  and  services  
produced  in  an  economy.  GDP  is  also  a  measure  of  national  income  /  
national  expenditure.  
• Nominal  GDP  measures  the  monetary  value  of  GDP  (this  may  include  the  
effects  of  inflation  in  raising  prices).  
• Real  GDP  measures  GDP  adjusted  for  effects  of  inflation.  It  measures  the  
actual  purchasing  power  of  consumers  in  an  economy.  
• GDP  per  capita  is  the  level  of  GDP  divided  by  population.    
o E.g.  if  real  GDP  increases  by  3%  and  the  population  rises  by  1%,  
the  real  GDP  per  capita  has  increased  by  2%.  
• Economic  growth  means  an  increase  in  real  GDP.  It  refers  to  an  increase  
in  the  total  value  of  goods  and  services  produced  in  an  economy.  
• The  rate  of  economic  growth  measures  the  annual  /  quarterly  %  change  
in  real  GDP.  
• Sustainable  economic  growth  requires  economic  growth  to  be  
maintained  for  a  long  period.  It  involves:  
o Low-­‐inflationary  growth  –  i.e.  avoid  temporary  boom  and  busts  
o Growth  that  is  environmentally  sustainable  
 

 
• This  graph  shows  the  quarterly  change  in  real  GDP  in  the  UK.    
• In  Q2  2014,  economic  growth  was  0.7%.  (approx..  an  annual  rate  of  2.8%).    
• In  2008/09,  economic  growth  was  negative  –  Real  GDP  was  falling.  

4  
 
Macro-­‐economic  objectives  of  government  
The  primary  economic  objectives  of  a  government  are  likely  to  be:  
1. Sustainable  economic  growth.  Most  governments  would  try  to  
maximise  sustainable  economic  growth  to  increase  living  standards  and  
help  create  employment.    
2. Low  inflation.  The  government’s  inflation  target  is  currently  CPI  2%  (+/-­‐
1).  The  government  wishes  to  both  avoid  high  inflation  and  also  the  threat  
of  deflation.  
3. Low  unemployment.  Most  governments  will  aim  for  full  employment  –  
or  to  minimise  the  rate  of  unemployment.  
4. Satisfactory  current  account/  balance  of  payments.  A  large  current  
account  deficit  could  be  an  economic  concern  (e.g.  weak  export  growth,  
reliance  on  capital  flows,  finance  deficit),  therefore,  governments  may  
wish  to  have  a  reasonable  low  deficit/surplus.  
Less  important  objectives  
5. Low  government  borrowing.  Governments  often  commit  to  fiscal  
targets  for  both  annual  borrowing  and  total  debt  (public  sector  net  debt).    
6. Stable  exchange  rate.  A  rapid  depreciation  in  the  exchange  rate  could  
cause  inflationary  pressures  and  instability,  therefore,  governments  may  
prefer  a  stable  exchange  rate.  
Other  minor  objectives  

• Issues  of  equality.  High  economic  growth  may  be  at  the  expense  of  
income  inequality.    Making  sure  growth  is  fairly  distributed  may  be  an  
objective  of  some  governments.  
• Environment.  High  economic  growth  could  cause  environmental  
problems  and  issues  for  long-­‐term  sustainability.  Looking  after  the  
environment  may  require  some  sacrifice  in  terms  of  economic  growth.  
 

Benefits  of  economic  growth    

• Higher  incomes.  Rising  real  GDP  enables  consumers  to  enjoy  more  goods  
and  services  and  enjoy  better  standards  of  living.  
• Lower  unemployment.  Economic  growth  encourages  firms  to  employ  
more  workers  creating  more  employment.  
• Improved  government  finances.  Economic  growth  creates  higher  tax  
revenues  and  there  is  less  need  to  spend  money  on  benefits  such  as  
unemployment  benefit.  Economic  growth  can  reduce  debt  to  GDP.  
• Improved  public  services.  With  increased  tax  revenues  the  government  
can  spend  more  on  the  health  care  and  education.  
• Money  can  be  spent  on  protecting  the  environment.  With  higher  real  GDP  
a  society  can  devote  more  resources  to  promoting  recycling  and  the  use  of  
renewable  resources.  

5  
 
Costs  of  economic  growth  
• Inflation.  If  growth  is  too  fast,  it  may  lead  to  inflation  
• Boom  and  bust  cycles.  If  economic  growth  is  too  fast  and  unsustainable,  it  
can  lead  to  boom  and  bust  cycles.  
• Environmental  problems.  Higher  growth  can  lead  to  more  pollution  and  
environmental  degradation.  
• Is  it  sustainable  in  the  long  term?  For  example,  does  growth  lead  to  
diminished  natural  resources?  

Recessions  
• A  recession  is  defined  as  a  situation  where  we  see  a  fall  in  real  GDP  for  
two  consecutive  quarters  (6  months).      

 
This  graph  shows  that  the  EU  economy  experienced  a  recession  in  2008/09  and  
2012/13.  

Characteristics  of  a  recession:  

1. Real  incomes  will  fall,  reducing  living  standards.  
2. Unemployment  tends  to  rise.  This  is  because  some  firms  will  go  out  of  
business,  making  many  jobs  redundant.  Also,  with  lower  demand,  firms  
will  have  less  demand  for  workers.  
3. Higher  government  borrowing.  In  a  recession,  tax  receipts  will  be  lower  
(e.g.  less  income  tax,  less  VAT).  Also,  the  government  will  need  to  spend  
more  on  benefits,  such  as  unemployment  benefits.  
4. Fall  in  asset  prices,  such  as  houses.  
 

6  
 
 Economic  development  
The  three  main  sectors  of  the  economy  are:  
1. Primary  sector  is  the  extraction  of  raw  materials  –  mining,  fishing  and  
agriculture.  
2. Secondary  /  manufacturing  sector  is  concerned  with  producing  
finished  goods,  e.g.  factories  making  toys,  cars,  food,  and  clothes.  
3. Tertiary  ‘service’  sector  is  concerned  with  offering  intangible  goods  and  
services  to  consumers.  This  includes  retail,  tourism,  banking,  
entertainment  and  I.T.  services.  
Economic  development  
Economic  development  is  concerned  with  quality  of  life  and  a  range  of  economic  
indicators  that  affect  economic  welfare.  These  include:  

• GDP  per  capita,  

• Health  care  /  life  expectancy,  
• Education  /  literacy,  
• Gender  equality,  
• Pollution  and  environmental  standards,  
• Access  to  basic  amenities,  such  as  water  and  good  quality  shelter,  
• Extent  of  welfare  state,  
• Increase  in  size  of  manufacturing  and  later  service  sector  of  the  economy,  
and    
• Relative  decline  in  primary  sector.  

Measuring  development  
1.  Real  GDP  per  capita.  GDP  measures  national  output  /  national  income/  
national  expenditure.  It  is  a  rough  measure  of  the  average  national  income  per  
person  in  society  (real  is  adjusted  for  inflation).    

• GDP  is  useful  for  measuring  the  level  of  economic  activity  and  average  
incomes.  However,  it  has  many  limitations  for  measuring  the  level  of  
economic  development.  

Limitations  of  GDP  as  a  measure  of  living  standards  

1. Difficult   to   measure.  It  is  difficult  to  calculate  the  total  output  of  an  economy,  
because  GDP  statistics  will  ignore  the  underground  economy,  as  transactions  
are  not  recorded.  Subsistence  farmers  who  grow  their  own  food  may  have  
zero  income  but  actually  be  quite  well-­‐off.  
2. Negative  externalities.  GDP  includes  negative  externalities,  such  as  
pollution  and  congestion;  therefore,  a  rise  in  real  GDP  will  often  overestimate  
living  standards  on  this  count.  For  example,  China’s  high  growth  has  come  at  
a  cost  of  harmful  pollution  and  growth  in  congestion.  

7  
 
3. Inequality.  GDP  per  capita  ignores  distribution  of  income;  some  people  may  
be  very  poor,  despite  the  country  being  rich.  Economic  development  requires  
a  reduction  in  absolute  and  relative  poverty.  
4. What  is  GDP  spent  on?  It  depends  what  the  economy  produces.    For  
example,  a  country  may  have  a  high  real  GDP  per  capita,  but  if  40%  of  GDP  is  
spent  on  military  expenditure,  this  has  little  impact  on  improving  living  
standards.  
5. Purchasing  power  parity.  When  comparing  countries’  GDP  in  a  common  
currency  like  the  dollar,  we  cannot  get  a  true  comparison,  because  there  will  
be  a  different  purchasing  power  of  the  local  currency,  e.g.  a  dollar  would  buy  
more  in  India,  than  in  Japan.    
6. How  hard  do  people  work?  GDP  does  not  take  into  account  how  hard  
people  work.    For  example,  if  you  increase  your  income  by  working  longer  
hours,  does  this  improve  living  standards?  
 
Evaluation  

• Although  there  are  limitations  to  using  GDP,  don’t  forget  that  it  is  a  good  
starting  point.    
• Higher  GDP  enables  more  goods  and  services  to  be  consumed.  Higher  GDP  
enables  better  public  services,  such  as  health  and  education.    
• Generally,  countries  with  higher  real  GDP  per  capita  have  better  living  
standards.  

Human  development  index  (HDI)  

The  HDI  is  an  alternative  measure  of  economic  welfare.  It  takes  into  account  real  
GDP  per  capita  but  also  includes  measures  such  as  health  and  education  
standards  in  a  country.  HDI  includes:  

• Life  Expectancy  Index.  Average  life  expectancy  compared  to  a  global  

expected  life  expectancy.  
• Education  Index    
o Mean  years  of  schooling  
o Expected  years  of  schooling  
• Income  Index.  Gross  national  income  (GNI)  at  purchasing  power  parity  
(PPP).  

Advantages  of  using  HDI  

• HDI  can  highlight  countries  with  similar  GDI  per  capita  but  different  
levels  of  economic  development.  
• It  includes  the  three  main  areas  of  economic  welfare:  average  incomes,  
education,  and  health  standards  (life  expectancy).  

8  
 
Limitations  of  Human  Development  Index  
• Divergence  within  countries.  For  example,  countries  like  China  and  Kenya  
have  widely  different  HDI  scores,  depending  on  the  region  in  question,  e.g.  
Northern  China  is  poorer  than  the  south-­‐east.  
• HDI  reflects  long-­‐term  changes  (e.g.  life  expectancy)  and  may  not  respond  
to  recent  short-­‐term  changes.  
• Life  expectancy  may  not  reflect  quality  of  healthcare  or  may  be  affected  
by  past  war.  
• Higher  national  wealth  GDI  may  not  necessarily  increase  economic  
welfare,  as  it  depends  how  that  wealth  is  spent.  
• Also,  higher  GDI  per  capita  may  hide  widespread  inequality  within  a  
country.  Some  countries  with  higher  real  GDI  per  capita  have  high  levels  
of  inequality,  e.g.  Russia  and  Saudi  Arabia.  
• Economic  welfare  depends  on  several  other  factors,  such  as  the  threat  of  
war,  levels  of  pollution,  access  to  clean  drinking  water  etc.  

The  Human  Poverty  Index  (HPI)    

This  is  like  HDI  but  also  takes  into  account  the  distribution  of  welfare  within  
a  country,  to  try  and  measure  relative  poverty  levels.  
Genuine  progress  indicator  (GPI)    
It  includes  GDP,  but  also  takes  into  account  all  the  factors  which  can  detract  
from  living  standards.  
GPI  takes  into  account  

• resource  depletion  
• pollution  and  long-­‐term  environmental  damage  
• Poverty  levels  

Sustainable  development  
Sustainable  development  places  greater  stress  on  achieving  long-­‐term  
improvements  in  economic  and  social  indicators.  Sustainable  development  
involves:  

• Protecting  environment  in  the  long-­‐term.  For  example,  economic  

development  could  involve  burning  more  fossil  fuels,  but  this  may  not  be  
sustainable  because  of  the  impact  on  the  environment.  
• Improving  education  and  skills  base  of  the  economy.  This  enables  
higher  labour  capital  and  more  potential  for  entrepreneurs  to  develop  
businesses.  
• Diverse  economic  development.  A  country  could  increase  GDP  by  
extracting  more  raw  materials,  however  this  lacks  sustainability  because  
raw  materials  are  finite.  Sustainable  development  requires  new  
industries  and  sectors  of  the  economy,  which  don’t  rely  on  exploitation  of  
environment.  

9  
 
Economic  development  and  sustainability  

 
This  model  (Kuznets  environment  diagram)  states  that  the  level  of  
environmental  degradation  depends  on  economic  development.  

• As  economies  develop  and  industrialise,  we  see  more  pollution  and  

environmental  degradation  (e.g.  steam  power,  use  of  fossil  fuels).  
• However,  at  a  certain  point,  economies  become  less  industrial  and  more  
service  sector  oriented.  This  leads  to  less  pollution  and  less  
environmental  degradation.  
• Also,  with  higher  incomes  people  have  the  luxury  of  becoming  more  
aware  of  the  environment  and  are  less  concerned  about  increasing  output.  
Evaluation  of  Kuznets  environmental  curve  

• However,  not  everyone  agrees  that  economic  development  will  inevitably  

reduce  environmental  degradation.  In  fact,  the  opposite  might  occur.  
• With  increased  economic  growth,  there  is  higher  output,  consumption,  
and  consequent  pollution.  The  biggest  polluters  are  those  countries  with  
high  real  GDP  per  capita.  
• It  depends  on  the  type  of  the  economy.  Some  developed  countries,  like  
Australia  and  Canada  have  continued  to  produce  raw  materials  and  
continue  mining.  Not  all  developed  economies  become  primarily  service  
sector  based.  
• It  depends  on  policies  adopted.  Developed  countries  have  the  potential  to  
limit  environmental  pollution,  but  higher  taxes  and  regulations  to  protect  
the  environment  may  be  unpopular  and  not  implemented.  

10  
 
Economic  growth  and  happiness  
The  UK  ONS  now  publishes  a  measure  of  ‘National  well  being’.  This  includes  ten  
segments  of  life  that  make  up  wellbeing,  including  the  economy,  relationships,  
personal  finance,  natural  environment,  education  and  skills,  governance,  what  
we  do,  and  health.  

• The  index  includes  positive  statements,  e.g.  unemployment  rate,  voting  

rates,  crime  rates.  
• The  index  also  includes  surveys  which  are  normative  opinions  from  
people  about  whether  they  are  satisfied,  e.g.  rating  of  social  life,  rating  of  
personal  health,  relative  satisfaction  with  life  and  the  environment.  
• The  index  measures  how  these  index  tools  change  over  time,  e.g.  the  
overall  index  of  national  wellbeing  would  rise  if  more  people  responded  
positively  to  questions  about  personal  wellbeing.  
• By  combining  statistics  and  surveys,  it  attempts  to  get  a  better  overall  
snapshot  of  living  standards  and  whether  people  are  likely  to  be  happy  
with  life.  
• It  is  an  attempt  to  move  away  from  relying  on  purely  financial  indicators,  
such  as  GDP  –  which  on  their  own  may  not  increase  wellbeing.  

Limitations  of  National  Wellbeing  index  

• Surveys  are  normative.  People’s  perceptions  of  satisfaction  may  change  
due  to  unexpected  factors.  
• People  may  not  always  respond  honestly  or  certain  people  may  not  want  
to  be  in  surveys  at  all.  
• Surveys  could  be  influenced  by  temporary  factors,  such  as  an  early  World  
Cup  exit  for  the  national  team.  
• It  is  so  wide  ranging  that  it  can  be  hard  to  see  overall  trends.  

Easterlin  Paradox  
This  studied  the  relationship  between  happiness  and  real  incomes  and  found:  

• High  incomes  do  correlate  with  happiness,  but  in  the  long  term,  increased  
income  doesn't  correlate  with  increased  happiness.  
The  impact  of  this  suggests  that  once  a  certain  standard  of  living  is  reached  in  a  
society,  government  policy  should  focus  on  improving  life  satisfaction  –  index  of  
well-­‐being  rather  than  economic  growth.  
Evaluation  

• The  paradox  is  disputed.  Some  economists  suggest  that  rising  real  
incomes  can  lead  to  increased  life  satisfaction.    
• Also,  it  is  hard  to  measure  happiness  because  it  is  such  a  normative  factor.    
• But,  it  is  understood  that  rising  incomes  alone,  are  not  necessarily  
sufficient  to  improve  well-­‐being.  

11  
 
Limitations  to  economic  growth  and  development  
• Poor  infrastructure.  Lack  of  transport  increases  cost  and  makes  trade  
more  difficult.  Land-­‐locked  countries  are  at  a  disadvantage,  because  cost  
of  trade  is  much  higher.  
• Human  capital  inadequacies.  Low  levels  of  education  and  training  limit  
the  range  of  goods  and  services  that  can  be  produced.  Countries  with  low  
levels  of  education  may  be  constrained  to  unskilled  industries,  such  as  
extraction  of  primary  products.  
• Primary  product  dependency.  Reliance  on  primary  products  (oil,  
minerals,  agriculture  etc.)  can  limit  economic  development.  Volatile  
prices  can  lead  to  fluctuating  export  earnings.  Primary  products  may  also  
be  finite  and  will  at  some  time  run  out.  
• Low-­‐income  elasticity  of  demand.  Primary  products  have  a  low-­‐income  
elasticity  of  demand,  so  countries  that  rely  on  primary  products  don’t  
benefit  as  much  from  global  growth.  
• Foreign  exchange  gap.  When  countries  develop  a  lack  of  foreign  
exchange,  e.g.  if  they  spend  money  on  debt  relief  and  imports  of  
commodities  but  struggle  to  export  goods.  
• Capital  /  human  flight.  Countries  with  a  poor  reputation  may  struggle  to  
attract  and  retain  capital.  Also,  the  best  skilled  workers  may  leave  for  
higher  wages  elsewhere.  

Strategies  to  promote  growth  and  development  

1.  Development  of  human  capital.  Government  spending  to  improve  education  
and  training  can  lead  to  improved  human  capital  and  higher  labour  productivity.  
This  is  important  for  leading  to  a  higher  skilled  economy.  

• However,  it  can  take  several  years  to  educate  workers.  Also,  government  
spending  is  not  guaranteed  to  improve  labour  productivity,  as  people  may  
be  reluctant  to  take  part  in  training  schemes,  or  the  schemes  may  not  
match  market  needs.  

2.  Investment  in  infrastructure.  Often,  the  biggest  stumbling  block  to  economic  
development  is  infrastructure,  such  as  transport.  If  countries  can  invest  in  new  
roads  and  railways,  it  will  help  improve  trade  and  increase  economic  growth.  

• However,  a  developing  economy  may  struggle  to  have  the  necessary  tax  
revenues  to  finance  these  investments  and  there  is  the  danger  of  
government  failure  (poor  information,  corruption  and  inefficiency).  

3.  Protectionism  /  infant  industry  argument.  Developing  countries  may  be  

stuck  producing  primary  products,  which  offer  limited  scope  for  development.  
To  develop,  they  may  need  to  use  tariff  protection  and  develop  greater  diversity  
in  their  economy,  such  as  protecting  new  manufacturing  industries.    

• Several  Asian  countries  used  a  degree  of  tariff  protection,  when  they  were  
developing.  

12  
 
 • However,  this  is  controversial,  as  it  breaks  the  desire  to  promote  free  
trade.  Tariff  protection  may  also  encourage  inefficiency,  because  domestic  
firms  are  ‘protected’  from  international  competition.  
4.    Foreign  aid.  (Overseas  Development  Assistance  ODA)  Aid  can  be  used  to  
finance  investment  in  infrastructure  and  human  capital.  This  can  increase  capital  
stock  /  aggregate  supply  and  can  enable  higher  growth  rates.  

• However,  it  depends  on  the  quality  of  the  aid.  Often,  aid  is  tied  to  
purchasing  donors’  exports  and  is  limited  in  value.  There  is  also  a  danger  
aid  could  be  siphoned  off,  due  to  corruption.  
5.  Foreign  direct  investment.  Africa  has  benefitted  from  inward  investment  
from  China  in  infrastructure.  China  has  gained  access  to  raw  materials  and,  in  
return,  has  built  roads  and  railways  to  transport  the  goods.  This  has  played  a  
role  in  economic  development.  

• However,  the  concern  is  that  developing  countries  may  have  to  pay  a  high  
cost  (losing  rights  to  their  own  raw  materials,  in  return  for  investment).  

IMF  
• The  International  Monetary  Fund  plays  a  role  in  offering  credit  to  
countries  that  run  into  difficulties  making  debt  payments.  The  IMF  can  
arrange  a  loan  to  bail  out  countries  in  difficulty.    
• However,  the  IMF  usually  insists  on  certain  criteria  to  accompany  the  loan.  
This  may  involve  free  market  supply  side  policies,  such  as  devaluation,  
control  of  inflation,  tightening  of  fiscal  policy,  and  structural  reforms  such  
as  privatisation.    
• Some  criticise  the  IMF  for  placing  too  much  pressure  on  economies  to  
reduce  inflation,  reduce  budget  deficits,  and  introduce  free  market  
policies  which  increase  inequality.  
 

World  Bank  
• The  World  Bank  is  an  international  financial  institution  which  gives  loans  
to  developing  economies.  
• The  official  goal  of  the  World  Bank  is  to  reduce  global  poverty.  
• The  World  Bank  is  committed  to  facilitating  free  trade  and  foreign  
investment.  
• It  can  help  fund  useful  infrastructure  investment,  aid  which  is  essential  to  
capital  flows  for  developing  economies.  
• It  has  attracted  criticism  for  encouraging  laissez  faire  economics  (e.g.  
privatisation)  as  conditions  for  loans.  This  can  increase  efficiency,  but  it  
can  also  lead  to  increased  inequality.  
• Others  argue  that  structural  reforms  promoted  by  the  World  Bank  can  
also  help  the  economy  in  the  long-­‐term.  
 

13  
 
 Circular  flow  of  income    
The  circular  flow  of  income  shows  how  money  flows  from  households  to  firms  
(to  buy  goods).  Then  firms  pay  households  wages  to  produce  goods.  

 
GDP  (Gross  Domestic  Product)  measures  national  income  —  the  total  wealth  of  a  
country.  The  circular  flow  of  income  shows  three  ways  to  calculate  GDP:  
1. Total  national  income  (wages,  dividends)  
2. Total  national  expenditure  (consumption  and  investment)  
3. Total  national  output  (value  of  goods  and  services  produced)  
 
• Nominal  income  is  the  monetary  figure.  
• Real  income  is  the  value  of  GDP  adjusted  for  inflation;  therefore,  it  shows  
the  actual  value  of  goods  and  services.    
• For  example,  if  the  GDP  increases  by  7%,  but  inflation  was  5%,  the  
real  increase  would  be  7-­‐5  =  2%.  

Injections  (J)  
This  is  an  increase  of  expenditure  into  the  circular  flow  of  income,  leading  to  an  
increase  in  aggregate  demand  (AD).  Injections  can  include:  

• Exports  (X)  —  spending  on  domestic  goods  from  abroad  

• Government  spending  (G)  
• Investment  (I)  —  spending  on  capital  goods  by  firms  

14  
 
Withdrawals  (W)    
Withdrawals  are  a  reduction  of  money  in  the  circular  flow,  sometimes  known  as  
leakages.  Withdrawals  can  include:  

• Saving  (S)  —  depositing  money  in  banks  

• Imports  (M)  —  spending  on  foreign  goods  
• Taxation  (T)  —  the  government  raising  money  from  consumers  and  firms  
Physical  and  monetary  flows  

• Physical  flows  involve  the  transfer  of  goods.  

• Monetary  flows  involve  the  sending  of  payments  to  workers  or  to  good.  
• For  example,  a  consumer  may  buy  an  import  from  Germany.  This  requires  
a  financial  flow  from  the  UK  to  Germany  (a  withdrawal).  Once  payment  is  
received  the  good  is  transferred  to  UK.  

Marginal  propensity  
• Marginal  propensity  to  consumer  (MPC)  is  the  %  of  extra  income  that  
is  spent,  e.g.  if  confidence  is  high,  the  MPC  will  be  higher.  
• Marginal  propensity  to  save  (MPS)  is  the  %  of  extra  income  that  is  
saved  (e.g.  bank  savings).  Higher  interest  rates  may  encourage  more  
saving.  
• Marginal  propensity  to  tax  (MPT)  is  the  %  of  extra  income  that  goes  in  
tax  payments.  This  is  determined  by  income  tax  rates  and  VAT  rates.  
• Marginal  propensity  to  import  (MPM)  is  the  %  of  extra  income  that  is  
spent  on  imported  goods  (and  leaves  the  UK  economy).  
• Marginal  propensity  to  withdraw  (MPW)  =  MPS+MPT+MPM.  
Average  propensity  

• Average  propensity  to  consume  (APC).  This  is  the  percentage  of  
income  that  is  spent  rather  than  saved.  
• Average  propensity  to  save  (APS).  This  is  percentage  of  income  that  is  
saved.  
Calculation  

If  a  person  has  income  of  £10,000  and  he  spends  £8,000,  saving  £2,000.  

• The  APC  is  0.8  

• The  APS  is  0.2  
If  income  increases  from  £10,000  to  £11,000  and  consumption  rises  £400.  

• The  MPC  is  0.4  (400/1000)  

15  
 
 Aggregate  demand    
Aggregate  demand  (AD)  is  the  total  demand  for  goods  and  services  in  the  
economy:  AD  =  C+I+G+(X-­‐M)    

• C  =  Consumer  expenditure  on  goods  and  services  (60%)  

• I    =  Gross  capital  investment  (spending  on  capital  goods,  e.g.  machines)    
• G  =  Government  spending    
• X    =  Exports      
• M  =  Imports    
 
Shift  in  AD  and  movement  along  the  AD  curve  

 
An  increase  in  the  price  level  (P1  to  P2)  causes  movement  along  the  AD  curve.  

• At  a  higher  price  level,  ceteris  paribus,  consumers  have  less  disposable  

income  (money  to  spend).  
• At  a  higher  price  level,  UK  exports  will  be  relatively  less  competitive,  
leading  to  lower  export  demand.  
• A  shift  in  the  AD  curve  would  occur  if  there  was  a  change  in  factors  like  
real  income;  higher  income  would  shift  AD  to  the  right.  Consumers  would  
buy  more  at  the  same  price  level.  
Shift  in  AD  

• If  there  was  an  increase  in  income,  the  AD  curve  would  shift  to  the  right  
(AD2).    
• AD  could  shift  to  the  right  if  there  was  a  rise  in  investment,  exports  or  
government  spending.  
 

16  
 
Determinants  of  aggregate  demand:  (AD)  (C+I+G+X-­‐M)  

Consumer  spending  (C)  

Consumer  spending  is  the  biggest  component  of  AD  (approx.  60-­‐65%  of  AD).  
Consumer  spending  is  determined  by:  

• Disposable  income.  This  is  income  after  taxes  and  benefits.  Rising  real  
wages  would  increase  the  disposable  income  and  shift  AD  to  the  right.  
• Saving.  The  alternative  to  spending  disposable  income  is  to  save.  If  the  
income  stays  constant  but  consumers  want  to  increase  their  savings,  then  
consumption  will  fall.  
• Consumer  confidence.  If  consumers  are  pessimistic  about  the  future,  
they  will  prefer  to  save,  pay  off  debt,  and  reduce  their  current  spending.  
Low  confidence  will  shift  AD  to  the  left.  High  confidence  will  encourage  
spending.  
• House  prices/  wealth.  Rising  house  prices  tend  to  increase  consumer  
spending  through  a  positive  wealth  effect.  In  the  UK,  many  people  own  
their  houses.  If  house  prices  rise,  they  could  gain  equity  withdrawal  —  re-­‐
mortgaging  their  house  and  taking  money  to  spend.  They  will  also  feel  
more  confident  if  their  house  is  worth  more.  
• Income  tax/VAT.  A  cut  to  income  tax  will  increase  the  consumers’  
disposable  income,  encouraging  spending.  
• Interest  rates.  Lower  interest  rates  reduce  the  cost  of  borrowing,  
encouraging  spending.  Lower  rates  also  make  consumption  more  
attractive  than  saving  in  a  bank.  
• Cost   of   living.  If  wages  stay  the  same,  but  the  cost  of  living  goes  down  (e.g.  
a  fall  in  petrol  prices),  people  will  have  more  disposable  income  and  
spend  more.  This  factor  causes  movement  along  the  AD  curve.  
 

Investment  (I)  
• Investment  accounts  for  about  15%  of  AD.    
• Investment  affects  both  AD  and  AS.  
• Investment  is  relatively  more  volatile  and  is  strongly  influenced  by  
confidence,  and  changes  in  the  rate  of  economic  growth.  

Factors  that  affect  investment  

1. Confidence.  If  businesses  are  optimistic  about  future  demand,  they  will  
need  to  increase  productive  capacity  and  start  to  invest  now.    If  
businesses  face  uncertainty,  they  will  cut  back  on  risky  investment.  
2. Animal  spirits.  Keynes  said  investment  was  heavily  influenced  by  the  
‘animal  spirits’  of  businessmen  —  did  people  expect  their  business  to  
grow?  This  confidence  can  quickly  change  depending  on  the  state  of  the  
economy.  

17  
 
 3. Interest  rates.  Investment  is  often  financed  by  borrowing  or  using  
savings.  Lower  interest  rates  make  it  cheaper  to  finance  investment  and  
make  more  projects  worthwhile.  
4. Availability  of  finance.  Businesses  may  wish  to  borrow  and  invest,  but  
access  to  credit  is  a  big  issue.    Banks  may  be  reluctant  to  give  a  small  
business  a  loan  because  it  is  a  risky  investment.  In  this  case,  it  may  
depend  on  businesses  finding  other  sources  of  credit,  such  as  the  stock  
market  or  private  investors.  
5. Government  regulation.  Some  businesses  may  be  put  off  investment  
because  of  the  heavy  cost  of  regulation,  e.g.  the  need  to  meet  
environmental  standards  and  labour  regulations.  On  the  other  hand,  
governments  could  encourage  investment  through  offering  regional  
subsidies.  
6. Economic  growth.  A  key  factor  in  determining  investment  is  the  rate  of  
economic  growth.  Improvements  in  the  rate  of  growth  and  AD  will  tend  to  
increase  investment.  The  demand  from  overseas  and  the  demand  for  
exports  are  also  important.  

Government  expenditure  (G)  

Government  spending  includes  transfer  payments  (e.g.  benefits)  and  direct  
spending,  such  as  capital  investment  in  public  roads.  In  2013/14,  the  UK  
government  spent  a  total  of  £722.9  billion  (44%  of  GDP).    
Government  spending  is  influenced  by:  

• Fiscal  policy.  The  government  may  choose  to  use  fiscal  policy  to  try  and  
influence  AD,  e.g.  in  a  recession,  the  government  could  borrow  more  and  
spend  on  capital  investment,  such  as  building  new  roads  and  railways.  

18  
 
 • Economic  cycle.  In  a  period  of  high  economic  growth,  tax  revenues  tend  
to  rise;  this  gives  the  government  more  money  to  spend  on  services  like  
the  NHS.  
• Political  cycle.  Government  may  cut  spending  after  an  election  to  try  and  
reduce  the  budget  deficit,  but  then  increase  spending  shortly  before  an  
election.  

Net  trade  (X-­‐M)  

The  UK’s  main  trading  partner  is  the  EU  (60%  of  trade),  though  the  proportion  of  
trade  with  developing  economies,  such  as  China  and  India,  is  rising.  

Factors  that  affect  (X-­‐M)  

1. Exchange  rates.  If  there  is  a  depreciation  of  the  exchange  rate,  exports  
will  be  cheaper,  and  imports  more  expensive.  This  will  tend  to  increase  
(X-­‐M)  and  increase  AD.  
2. Economic  growth.  If  the  UK  growth  is  relatively  higher  than  other  
countries,  we  will  see  a  rise  in  import  spending,  and  this  will  reduce  net  
(X-­‐M).  But  if  there  is  strong  growth  in  Europe,  this  will  lead  to  higher  (X-­‐
M)  and  higher  AD.  
3. Competitiveness.  If  the  UK  has  a  lower  inflation  rate  than  its  competitors,  
then  UK  exports  will  become  relatively  cheaper.  Improved  
competitiveness  could  be  due  to  lower  wages  or  higher  productivity.  
4. Non-­‐price  factors.  In  addition  to  price,  the  quality  and  desirability  of  UK  
goods  and  services  will  be  important.  If  UK  firms  can  produce  better  
quality  goods  and  services  with  unique  selling  points,  the  demand  for  UK  
exports  will  rise,  and  the  demand  will  be  more  inelastic.  
5. Tariffs  and  protectionist  measures.  If  a  country  faced  high  tariffs  on  
exports,  it  would  reduce  demand.  For  example,  if  the  UK  left  the  EU,  it  
may  find  that  there  are  higher  costs/tariffs  on  exports  to  Europe.  

Accelerator  effect  
The  accelerator  effect  states  that  investment  levels  are  related  to  the  rate  of  
change  of  GDP.    

• Thus,  an  increase  in  the  rate  of  economic  growth  will  have  a  
corresponding  larger  increase  in  the  level  of  investment.    
• This  suggests  that  investment  can  be  quite  volatile.  An  economic  
downturn  leads  to  a  big  drop  in  investment.  
However,  it  should  be  borne  in  mind  that  the  accelerator  is  not  the  only  
determinant  of  investment.  

• There  can  be  time  lags  between  changes  in  rate  of  economic  growth  and  
the  decision  to  invest.  
• Firms  will  also  be  affected  by  other  factors,  such  as  interest  rates  and  
‘animal  spirits’  /  confidence.  

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 Aggregate  supply  (AS)  
Aggregate  supply  (AS)  is  the  total  productive  capacity  of  the  economy.  It  is  the  
sum  of  all  the  individual  supply  curves  for  particular  goods.  

The  AS  curve  shows  maximum  potential  output;  there  is  a  strong  correlation  
with  a  production  possibility  frontier  (PPF)  curve  from  unit  1,  which  also  shows  
the  maximum  potential  of  an  economy.  
Shift  and  movement  in  AS  

 
• In  the  diagram  on  the  left,  the  AS  curve  has  shifted  to  the  left,  leading  to  
a  higher  price  and  lower  real  GDP.  
• In  the  diagram  on  the  right,  there  is  a  shift  in  AD.  This  causes  a  higher  
price  level  (P1  to  P2)  and  movement  along  the  AS  curve.  

Short-­‐run  aggregate  supply  SRAS  

• In  the  short  run,  aggregate  supply  is  elastic.    
• Higher  prices  encourage  firms  to  supply  more  and  increase  capacity.  For  
example,  firms  can  pay  workers  to  do  overtime.    
 

20  
 
Factors  that  affect  short-­‐run  aggregate  supply  
In  the  short  run,  AS  can  be  determined  by  factors  that  affect  the  cost  of  
production.  These  include:  

• The  price  of  raw  materials,  e.g.  oil,  metals,  food,  gas,  food  and  electricity.  
• The  exchange  rate.  A  devaluation  in  the  currency  will  increase  the  cost  
of  many  imported  raw  materials,  such  as  oil  and  shift  SRAS  to  the  left.  
• Taxes  and  subsidies.  A  rise  in  VAT  or  excise  duty  will  increase  the  cost  of  
goods  and  shift  SRAS  to  the  left.  
• Money  wages.  A  rise  in  wages  will  increase  the  cost  of  firms  and  shift  
SRAS  to  the  left.  

Effect  of  increase  in  the  price  of  oil  on  SRAS  

An  increase  in  the  price  of  oil  would  shift  SRAS  to  the  left.  This  is  sometimes  known  as  a  
supply  side  shock.  

A  supply-­‐side  shock  could  also  occur  as  a  result  of:  

• Rapid  devaluation,  causing  a  rise  in  the  price  of  imported  goods.  
• Rise  in  the  price  of  commodities,  such  as  food  or  coffee.  
• Powerful  trade  unions  causing  a  rapid  rise  in  wages.  
Examples  of  supply-­‐side  shocks  

• 1970s:  Oil  prices  trebled,  leading  to  a  double-­‐digit  inflation  and  the  
recession  of  1973/74.  
• 2008:  Oil  prices  rose  sharply  at  the  start  of  the  credit  crunch  causing  
cost-­‐push  inflation  —  even  as  the  economy  was  declining.  

21  
 
Long-­‐run  aggregate  supply  (LRAS)  
In  the  long  run,  AS  is  determined  by  the  quantity  of  factors  of  production  and  the  
productivity  of  labour/capital.    

 
The  long-­‐run  aggregate  supply  curve  illustrates  the  normal  capacity  level  of  
output  in  the  economy.  It  may  be  referred  to  as  ‘full  capacity’  level  of  output.  

Factors  affecting  LRAS    

• Population.  A  rise  in  the  number  of  working  age  people  will  increase  the  
labour  force  and  increase  productive  capacity.  The  working  age  
population  can  be  affected  by  birth  rates  and  net  migration.  The  UK  
labour  force  has  increased  due  to  net  migration  in  the  past  decade.  
• Technology.  Technological  improvements  are  one  of  the  biggest  factors  
affecting  labour  productivity,  e.g.  the  internet  makes  it  easier  for  firms  to  
check  costs  and  prices.  
• Investment.  If  firms  or  the  government  invest  in  increasing  the  capital  
stock,  we  will  see  higher  AS  in  the  long  run.  
• Education  and  skills.  Improved  education  and  vocational  skills  enable  
workers  to  be  more  productive  and  offer  higher  added  value,  increasing  
productive  capacity.  
• Infrastructure.  Improved  transport  links  reduce  the  cost  of  transport  
and  encourage  trade;  this  is  important  for  boosting  productive  capacity.  
• Government  policies.  The  government  can  affect  the  LRAS  by  its  supply-­‐
side  policies  on  education,  competitiveness  and  regulation.  For  example,  
privatisation  and  deregulation  may  increase  efficiency  and  competitive  
pressure  in  industries  like  gas  and  electricity.  
• Attitudes  to  enterprise.  A  stable  economic  and  political  climate  may  
encourage  entrepreneurs  to  invest  and  develop  businesses.  
• Financial  system.  A  strong  banking  system  that  can  allow  firms  to  gain  
credit  for  investment  will  help  increase  productive  capacity.  A  fragile  
banking  system  could  damage  LRAS.  

22  
 
Different  views  of  the  LRAS  

 
Different  economists  have  different  views  about  the  LRAS.  

• On  the  left,  the  classical  view  is  that  LRAS  is  inelastic.  In  this  case,  a  rise  in  
AD  will  cause  inflation  in  the  long  run.  Economic  growth  requires  LRAS  to  
shift  to  the  right.  
• On  the  right,  the  Keynesian  view  is  that  there  can  be  spare  capacity  in  the  
long  run  (e.g.  prolonged  recession),  therefore  an  increase  in  AD  can  cause  
higher  real  GDP  (if  there  is  spare  capacity).  
 

Which  AS  curve  to  draw?  

• Many  students  ask  —  which  curve  should  I  draw?  We  have  SRAS  and  two  
LRAS.  
• On  many  occasions,  it  doesn’t  matter  because  the  important  thing  is  to  
show  the  basic  idea  of  AD  and  AS.  
• However,  it  can  be  important  to  distinguish  between  SRAS  and  LRAS.  A  
rise  in  oil  prices  shifts  SRAS.  Capital  investment  would  affect  LRAS.  
• If  you  want  to  show  how  AD  can  increase  real  GDP,  it  is  helpful  to  draw  a  
SRAS  or  Keynesian  LRAS.  

 
 
 

23  
 
Macroeconomic  equilibrium  
Equilibrium  national  income  occurs  where  AD=AS.  

 
In  this  example,  there  is  a  fall  in  AD,  leading  to  a  change  in  equilibrium  national  
income.  Real  GDP  falls  from  Y1  to  Y2.  

Increase  in  AD  

Suppose  that  we  have  an  increase  in  injections  into  the  circular  flow.  For  
example,  a  rise  in  export  demand  due  to  increased  economic  growth  in  Europe.    

 
This  increase  in  AD  will  lead  to  higher  real  GDP  and  inflation.  

24  
 
 Economic  growth  
Short-­‐run  economic  growth  

 
If  there  is  spare  capacity  (e.g.  at  Y1)  —  in  the  short  run,  an  increase  in  AD  causes  
an  increase  in  real  GDP.    
Short  run  growth  using  production  possibility  frontier  

 
Using  a  production  possibility  frontier,  this  short  run  economic  growth,  would  involve  a  
movement  from  point  D  to  point  A.  

25  
 
Causes  of  economic  growth  in  the  short  term  
Demand-­‐side  factors  that  can  increase  economic  growth  could  include:  

• Lower  interest  rates  —  reducing  the  cost  of  borrowing  and  leading  to  
higher  investment  and  higher  consumption.  
• Rising  house  prices  —  leading  to  a  positive  wealth  effect,  encouraging  
consumer  spending.  
• Lower  taxes  —  increasing  disposable  income.  
• Higher  confidence  in  the  economy  —  encouraging  spending  and  
investment.  
• Rising  exports  —  from  higher  growth  in  other  countries.  

Limits  to  economic  growth  in  the  short  run  

In  the  short  run,  there  is  a  limit  to  how  much  AD  can  increase  economic  growth.  

 
• At  Y2,  the  economy  has  reached  full  employment.    
• Any  further  rise  in  AD  will  just  cause  inflation.  
 

 
 

26  
 
Long-­‐run  economic  growth  

 
With  long-­‐run  economic  growth  we  see  an  increase  in  both  LRAS  and  AD.  This  
rise  in  LRAS  represents  an  increase  in  the  productive  capacity  of  the  economy.  
Factors  that  could  increase  LRAS  include:  

• Increased  investment  in  productive  capacity  

• Better  education  and  training  to  increase  labour  productivity  
• Improvement  in  technology,  leading  to  lower  costs  of  production  
• Improvements  in  infrastructure,  such  as  transport  
• Inward  investment  from  overseas  multinational  firms  
• Net  migration  causing  a  rise  in  the  labour  supply  
Long  run  economic  growth  using  PPF  

 
If  the  PPF  shifts  to  the  right,  we  get  economic  growth  in  the  long  run.  

27  
 
Economic  cycle  
The  trade  cycle  (or  economic  cycle)  refers  to  how  the  rate  of  economic  growth  
can  be  variable  and  go  in  cycles  of  boom  and  bust.  

 
This  shows  how  the  actual  growth  rate  can  vary  from  the  long-­‐run  trend  rate.  

The  long  run  trend  rate  of  economic  growth.    This  is  the  sustainable  rate  of  
economic  growth  in  an  economy.  For  example  in  the  UK,  this  is  about  2.5%.  

 
This  shows  the  growth  in  real  GDP  compared  to  the  trend  rate  of  growth.  In  2008-­‐12,  
growth  stagnated.  

28  
 
Factors  that  determine  long  run  trend  rate  
Essentially  the  long  run  trend  rate  is  determined  by  the  growth  in  productive  
capacity,  the  growth  in  long  run  aggregate  supply.    
If  productive  capacity  increases  3%,  then  this  enables  economic  growth  of  3%,  
with  minimal  inflation.  Some  of  the  main  factors  which  determine  the  long-­‐run  
trend  rate  will  be:  

• Supply  side  improvements,  e.g.  improvements  in  technology.  

• Labour  productivity,  e.g.  skills  and  motivation  of  workers.  
• Efficiency  gains  from  policies,  e.g.  privatisation  and  deregulation.  
• Size  of  labour  force.  
 

The  Multiplier    
 

The  multiplier  effect  occurs  when  a  change  in  injections  causes  a  bigger  final  
change  in  real  GDP.  

 
For  example,  if  the  government  increased  G  (government  spending)  by  £10  
billion,  and  this  led  to  an  increase  in  real  GDP  of  £16bn,  we  say  the  multiplier  
effect  is  16/10  =  1.6  

Why  do  we  get  a  multiplier  effect?  

1. Suppose  we  have  a  depressed  economy  with  spare  capacity  and  
unemployed  workers.  If  the  government  spends  £10  billion  on  building  
roads,  they  will  employ  workers.  Income  and  spending  will  rise  by  £10bn.    
2. But  the  unemployed  will  now  have  extra  money  to  spend.  They  will  buy  
products  from  shops,  which  will  now  see  improved  incomes  and  spend  
more.  
3. In  other  words,  the  initial  spending  doesn’t  just  stay  with  one  person.  
There  are  knock-­‐on  effects.  Higher  spending  leads  to  more  income  for  
others  and,  therefore,  further  rounds  of  spending.  

29  
 
  
Initially,  a  rise  in  injections  causes  AD  to  increase  to  AD2.  But  because  of  the  
multiplier  effect  and  further  rounds  in  spending,  we  get  another  increase  in  AD  
to  AD3,  causing  a  bigger  final  increase  in  real  GDP.  

• The  multiplier  effect  will  be  bigger  if  consumers  spend  a  high  %  of  their  
income.  However,  if  confidence  is  low  and  people  save  the  extra  income,  
the  multiplier  effect  will  be  low.    
• The  multiplier  effect  will  also  be  lower  if  most  of  the  spending  goes  on  
imports,  because  this  is  a  leakage  from  economy.  

What  determines  the  multiplier  effect?  

 

 
• Marginal  propensity  to  consumer  (MPC)  is  the  %  of  extra  income  that  
is  spent,  e.g.  if  confidence  is  high,  the  MPC  will  be  higher.  
The  alternative  to  spending  money  is  that  the  money  will  be  withdrawn  from  the  
circular  flow.  For  example,  higher  income  could  lead  to:  

• More  saving,  
• Paying  tax,  and  
• Spending  on  imports.  

30  
 
Calculating  the  size  of  the  multiplier  
The  multiplier  effect  is  determined  by  the  marginal  propensity  to  consume  
(MPC).    

• The  higher  the  marginal  propensity  to  consume,  the  bigger  the  multiplier.  
• If  consumers  received  extra  money  but  none  of  this  was  spent  directly  in  
the  UK,  there  would  be  no  multiplier  effect.    
• If  consumers  have  a  high  marginal  propensity  to  consume,  then  there  will  
be  bigger  knock-­‐on  effects  throughout  the  economy.  
 

Example  
If  the  government  increased  spending  by  £20bn  (financed  by  borrowing),  and:  

• Marginal  propensity  to  consume  (MPC)  was  =  0.3  

• The  multiplier  effect  =  1/(1-­‐0.3)  =  1/0.7  =  1.42  
• The  final  increase  in  real  GDP  will  be  £20bn  ×  1.42  =  £28.57bn  
 

Boom  phase  of  economic  growth  

A  boom  is  a  period  of  rapid  growth.  It  is  characterised  by:  

• Economic  growth  above  the  long-­‐run  trend  rate.  

• Rise  in  spending  on  imports,  causing  a  current  account  deficit.  
• With  AD  rising  faster  than  AS,  there  will  be  a  rise  in  inflation.    
• Falling  unemployment.  
• Rapid  rise  in  investment.  Due  to  accelerator  effect,  rising  growth,  can  
cause  a  bigger  rise  in  investment,  leading  to  higher  growth.  
• Multiplier  effect.  Due  to  rise  in  investment,  we  can  also  see  a  multiplier  
effect,  with  the  initial  increase  in  investment  causing  knock  on  effects.  
• Positive  output  gap.  
• Asset  prices,  like  housing  and  shares  are  likely  to  be  rising.  Often  in  a  
boom,  asset  prices  rise  very  rapidly  —  helped  by  over-­‐exuberance.    
• The  rise  in  house  prices,  in  turn,  creates  a  positive  wealth  effect  and  more  
spending.  
• Rapid  growth  in  credit  as  firms  and  consumers  borrow  more  to  finance  
higher  consumption  and  investment  levels.  
• High  levels  of  consumer  and  business  confidence.  Keynes  termed  it  
‘animal  spirits’  of  businessmen.    
• In  a  boom  we  often  get  a  phenomenon  known  as  ‘herding’.  This  is  where  
people  copy  the  behaviour  of  others.  For  example,  if  other  people  are  
buying  houses  and  shares,  they  give  other  people  the  confidence  to  also  
buy  houses  and  shares.    

31  
 
  
 

• This  shows  UK  economic  growth  since  1949.  It  shows  that  economic  
growth  is  often  cyclical/volatile.  
• Between  1992  and  2007,  the  UK  had  the  longest  period  of  economic  
expansion  on  record.  
• Graph  shows  UK  had  recessions  in  1980/81,  1991  and  2008/09.  

Recession/  downturn  phase  of  economic  growth  

The  official  definition  of  a  recession  is  two  consecutive  quarters  of  negative  
growth.  Features  of  a  recession  include:  

• Falling  GDP  —  negative  economic  growth  

• Rising  unemployment  (demand-­‐deficient/cyclical  unemployment)  
• Improving  the  current  account  as  import  spending  falls  
• Fall  in  investment  
• Falling  asset  prices,  such  as  housing  and  shares  
• Negative  confidence  
• Negative  output  gap  

Balanced/stable  period  of  economic  growth  

• Growth  rate  close  to  long-­‐run  trend  rate.  A  rate  that  is  sustainable  for  a  
long  time.  
• AD  growing  at  similar  rate  to  AS,  causing  inflation  rate  to  remain  low.  
• Satisfactory  balance  of  payments.  
• Low  unemployment.  
• No  boom  in  asset  prices,  but  stable  levels  of  borrowing  and  saving.  

32  
 
Output  gaps  
An  output  gap  is  the  difference  between  potential  GDP  and  actual  GDP.  In  the  
real  world,  the  rate  of  economic  growth  is  rarely  constant.    We  can  have  positive  
and  negative  output  gaps.  

Positive  output  gap  

A  positive  output  gap  will  occur  when  the  actual  economic  growth  is  above  the  
sustainable  potential,  e.g.  if  the  long-­‐run  trend  rate  is  2.5%,  but  we  have  growth  
of  4%.  

 
In  this  diagram,  firms  are  temporarily  producing  at  Y2,  which  is  greater  than  Yf  
(full  employment).  They  have  increased  output  in  the  short  run  (e.g.  getting  
workers  to  do  overtime).  But  this  is  stretching  potential  output  and  is  
unsustainable.  

A  positive  output  gap  occurs  when  AD  increases  faster  than  AS.  A  positive  output  
gap  leads  to:  

• Inflation,  because  the  demand  is  growing  faster  than  the  supply.  
• Lower  unemployment  due  to  greater  demand  for  workers.  
• A  deterioration  in  the  current  account  balance  of  payments.  
• The  Central  Bank  may  deal  with  the  inflation  by  putting  up  interest  rates.  
• The  ‘boom’  will  be  unsustainable  and  may  lead  to  an  economic  downturn.    
• PPF  curve:  In  a  boom,  output  will  be  on  the  PPF  curve,  or  just  exceeding,  
due  to  short-­‐term  extension  in  supply.  
 
33  
 
Negative  output  gap  
A  negative  output  gap  occurs  when  the  economic  growth  is  below  the  
sustainable  potential,  e.g.  it  could  be  due  to  very  low  economic  growth  at  0.5%,  
or  a  recession  with  negative  economic  growth  (-­‐1.2%).  
 

 
With  a  negative  output  gap,  the  real  GDP  will  be  less  than  potential.    The  output  
would  be  within  the  PPF  curve.  This  will  be  due  to  low  aggregate  demand.  For  
example,  a  negative  output  gap  could  be  caused  by:  

• Cutting  government  expenditure  (austerity)  

• Falling  house  prices  causing  a  fall  in  wealth  and  consumer  spending  
• Rapid  rise  in  interest  rates,  which  increases  the  cost  of  borrowing  

Impact  of  negative  output  gap  

• Resources  wasted  —  unemployment  
• Low  rates  /  negative  rates  of  economic  growth  
• Inflation  falling  below  target  
• Fall  in  investment  
• Higher  government  borrowing  due  to  falling  tax  revenues  and  higher  
spending  on  benefits  
• PPF  curve:  With  negative  output  gap,  output  will  be  within  PPF  curve.  

 
 

34  
 
 Trends  in  macroeconomic  indicators  
UK  economic  growth  since  1980  

 
Graph  showing  economic  growth  and  the  recessions  of  1980,  1991  and  2008.  

 
• Labour  productivity  measures  output  per  worker.  
• Graph  showing  UK  productivity  grew  30  percentage  points  from  1990  to  2005.  
This  was  a  faster  rate  of  productivity  growth  than  Germany.  
• Note:  This  shows  relative  change  in  that  time  period.  It  doesn’t  mean  UK  
productivity  is  higher  than  Germany.  

35  
 
UK  Productivity  

 
Since  2008,  UK  labour  productivity  growth  has  been  poor  –  well  below  past  trends.  UK  
productivity  is  important  for  determining  long-­‐run  trend  rate.  

 
Graph  showing  correlation  between  UK  economy  growth  and  Eurozone.    
Since  2013,  the  UK  has  had  marginally  higher  rates  of  growth  than  the  Eurozone.  

36  
 
UK  inflation  and  interest  rates  

Inflation has been relatively low in the UK in the past 20 years. Interest rates were cut to zero in 2009.

Rising house prices creates a positive wealth effect. House prices fell in 2009, during financial crisis.

37  
 
 Unemployment  and  employment  
Unemployment  is  defined  as  when  someone  is  not  working,  but  is  actively  
seeking  work  and  willing  to  take  a  job.  

• Under-­‐employment  occurs  when  someone  is  working  part-­‐time  (e.g.  on  

a  zero-­‐hour  contract),  but  would  prefer  to  work  full-­‐time.    
• Economic  inactivity  occurs  when  people  are  not  in  the  labour  force.  
They  are  neither  working  nor  looking  for  work.  They  could  include  
categories  such  as  early  retirement,  disillusioned  long-­‐term  unemployed,  
long-­‐term  sickness,  disability,  etc.  
• Full  employment  means  that  the  unemployment  rate  is  very  low  or  close  
to  3%  (with  just  some  frictional  unemployment).  
• Full  employment  can  also  refer  to  the  economy  operating  on  the  PPF  
curve  (at  full  capacity)  so  there  is  no  demand  deficient  unemployment.  

Measuring  unemployment  
1.  Claimant  count  method  

This  is  the  official  government  method  of  calculating  unemployment.  It  counts  
the  number  of  people  receiving  benefits  (Jobseeker’s  Allowance).  

38  
 
Problems  with  claimant  count  

• The  claimant  count  excludes  many  who  might  be  looking  for  work.  It  
excludes  people  over  60/under  18,  people  on  government  training  
schemes,  and  married  women  looking  to  return  to  work.    
• Very  strict  rules  mean  that  you  can  lose  your  Jobseeker’s  Allowance  if  you  
miss  an  interview  or  refuse  to  take  certain  jobs.  
• Some  people  may  claim  benefits  whilst  still  working  in  the  “black  market”.  
 
2.  The  Labour  Force  Survey  

This  is  a  survey  asking  60,000  people  whether  they  were  unemployed  and  
whether  they  were  looking  for  a  job.  It  includes  some  people  not  eligible  for  
benefits  but  who  still  meet  the  criteria  of  being  unemployed.  
Potential  problems  of  Labour  Force  Survey  

• People  may  not  answer  honestly,  but  exaggerate  their  situation.  

• It  is  only  a  sample;  it  depends  on  accurate  profiling.  
• People  may  have  different  conceptions  of  actively  seeking  work.  
• People  who  are  employed  on  temporary  contracts,  or  working  part-­‐time  
(underemployed)  may  be  hard  to  classify  as  either  working  or  employed.  

UK  unemployment  %  since  1992.  

39  
 
Economic  costs  of  unemployment  
• Loss  of  earnings  for  the  unemployed,  leading  to  lower  living  standards.  
• More  difficulty  getting  work  in  the  future,  as  the  unemployed  lose  ‘on-­‐the-­‐
job  skills’  and  may  become  less  attractive  to  future  employers.  
• Stress  and  health  problems  of  being  unemployed.  
• Increased  government  borrowing.  The  government  spends  more  on  
unemployment  and  related  benefits,  and  receives  less  income  tax.  
• Lower  GDP  for  the  economy  and  possible  negative  multiplier  effect.  
• Increased  social  division  between  the  unemployed  and  employed.  

Causes  of  unemployment  

1.  Frictional  unemployment.  This  is  unemployment  caused  by  people  moving  
between  jobs,  e.g.  graduates  or  people  changing  jobs.  There  will  always  be  some  
frictional  unemployment,  as  it  takes  time  to  find  a  job.    

2.  Structural  unemployment.    This  is  unemployment  due  to  a  mismatch  of  

skills  in  the  labour  market.  It  can  be  caused  by:  

• Occupational  immobility.  This  refers  to  the  difficulties  in  learning  new  
skills  applicable  to  a  new  industry.  For  example,  a  former  manual  
labourer  may  find  it  hard  to  retrain  in  a  new,  high-­‐tech  industry.  
• Geographical  immobility.  This  refers  to  the  difficulty  in  moving  regions  
to  get  a  job,  e.g.  someone  unemployed  in  South  Wales  may  find  it  difficult  
to  move  to  London,  where  housing  is  expensive.  We  often  see  higher  
unemployment  in  depressed  regions.  
3.  Classical  or  real-­‐wage  unemployment.  This  occurs  when  wages  in  a  
competitive  labour  market  are  pushed  above  the  equilibrium.  This  could  be  
caused  by  minimum  wages  or  trade  unions.  

 
In  a  competitive  labour  market,  a  minimum  wage  above  the  equilibrium  will  cause  real-­‐
wage  unemployment  of  Q3-­‐Q1.  

40  
 
4.    Demand-­‐deficient  or  ‘cyclical  unemployment’.  This  occurs  when  there  is  a  
fall  in  AD,  leading  to  a  decline  in  national  income.  For  example,  a  European  
recession  would  cause  less  demand  for  UK  exports;  therefore,  UK  firms  will  
employ  fewer  workers.    

 
The  fall  in  AD  leads  to  a  decline  in  real  GDP.  With  less  output,  firms  demand  fewer  
workers.  

5.  Voluntary  unemployment.  This  occurs  when  people  turn  down  the  

opportunity  to  work  at  the  going  wage  rate.  For  example,  generous  
unemployment  benefits  may  encourage  people  to  stay  on  benefits  rather  than  
take  a  job.    

• This  is  opposed  to  involuntary  unemployment,  where  people  are  unable  to  
get  a  job  at  the  going  wage  rate.  For  example,  due  to  structural  or  
frictional  unemployment.  
6.  Seasonal  unemployment.  In  many  countries,  unemployment  rates  will  be  
higher  in  certain  seasons.  For  example,  in  the  tourist  off-­‐season  unemployment  
rates  will  be  higher.  Unemployment  statistics  are  often  seasonally  adjusted  to  
take  into  account  lower  rates  during  busy  time  periods.  
 

 
 

41  
 
The  natural  rate  of  unemployment  
The  natural  rate  of  unemployment  is  the  rate  of  unemployment  when  the  labour  
market  is  in  equilibrium.    

 
• The  natural  rate  is  the  difference  between  those  who  would  like  a  job  at  
the  current  wage  rate,  and  those  who  are  willing  and  able  to  take  a  job.  
• The  natural  rate  of  unemployment  includes  frictional  and  structural  
unemployment.  The  natural  rate  of  unemployment  is  unemployment  
caused  by  supply-­‐side  factors  rather  than  demand-­‐side  factors.  

What  determines  the  natural  rate  of  unemployment?  

• Availability  of  job  information.  
• Quality  of  education  and  retraining  schemes,  which  affect  levels  of  
occupational  immobilities.  
• Degree  of  geographical  labour  mobility,  can  workers  move  to  where  jobs  
are  available?  
• Flexibility  of  the  labour  market,  e.g.  powerful  trade  unions  may  be  able  to  
restrict  the  supply  of  labour  to  certain  labour  markets.  
• Hysteresis.  A  rise  in  unemployment  caused  by  a  recession  may  cause  the  
natural  rate  of  unemployment  to  increase.  This  is  because  when  workers  
are  unemployed  for  a  time  period  they  become  deskilled  and  demotivated.  
• Monetarists  believe  that  unemployment  is  primarily  due  to  supply-­‐side  
factors  —  the  natural  rate  of  unemployment.  They  believe  demand-­‐side  
unemployment  will  only  be  temporary.  

42  
 
Explaining  the  changing  natural  rate  of  unemployment  
It  has  been  argued  that  the  UK  has  seen  a  fall  in  the  natural  rate  of  
unemployment  since  the  1980s.    This  has  been  explained  by:  

• Increased  labour  market  flexibilities,  e.g.  less  powerful  unions,  more  self-­‐
employment,  and  more  temporary  contracts.  
• Privatisation  has  helped  increase  the  competitiveness  of  the  industry,  
leading  to  more  flexible  labour  markets.  
• Lower  wage  increases  making  firms  more  willing  to  keep  workers.  
 

• Unemployment  peaked  in  1983,  1993  and  2012;  these  were  after  the  
economic  recessions.  
• Unemployment  fell  constantly  from  1993  to  2005  due  to  the  long  period  
of  economic  growth.  
• During  the  2010-­‐13  recession,  unemployment  was  lower  (8.5%  max)  
compared  to  the  recessions  of  early  1980s  (12%)  and  1990s  (10.5%).    
• This  was  possibly  due  to  a  lower  natural  rate  of  unemployment  in  the  
2000s.
• In  the  2000s,  there  was  more  under-­‐employment  —  people  working  part-­‐
time  and  self-­‐employed.    This  increased  labour  market  flexibility  helped  
to  keep  the  unemployment  rate  low.

43  
 
Policies  to  reduce  unemployment  
1.  Fiscal  and  monetary  policy  (demand-­‐side)  
If  there  is  demand-­‐deficient  unemployment,  the  government  could  pursue  
expansionary  fiscal  policy  by  cutting  income  tax  to  boost  consumer  spending  and  
aggregate  demand.  Higher  AD  should  lead  to  higher  economic  growth  and  should  
encourage  firms  to  take  on  more  workers.  

• However,  demand-­‐side  policies  may  cause  higher  rates  of  inflation  and  
will  not  reduce  supply-­‐side  unemployment,  like  structural  unemployment.  

2.  Education  and  training  

Structural  unemployment  could  be  solved  by  offering  retraining  and  new  skills  
for  the  long-­‐term  unemployed.  This  gives  a  better  opportunity  for  the  
unemployed  to  find  work  in  new  industries.  

• However,  it  would  cost  money,  and  it  may  prove  difficult  for  some  older  
workers  to  retrain  in  new  industries  and  develop  new  skills.  
3.  Better  job  information  and  interview  practice  
This  could  help  reduce  frictional  unemployment  by  giving  the  unemployed  
better  information  about  available  job  vacancies,  and  also  offering  tips  for  the  
unemployed  to  get  work.  
4.  Lower  benefits  and  taxes  
Lower  benefits  and  income  tax  may  increase  the  incentive  for  the  unemployed  to  
look  for  work  rather  than  stay  on  benefits.  This  could  reduce  frictional  
unemployment.  

• However,  benefits  in  the  UK  are  already  quite  low;  reducing  benefits  may  
increase  poverty,  but  will  not  create  any  jobs.    
5.  Reducing  minimum  wages  

If  the  minimum  wage  is  above  the  equilibrium,  reducing  it  to  the  equilibrium  will  
enable  firms  to  employ  more  workers,  which  reduces  real-­‐wage  unemployment.  

• However,  demand  for  labour  may  be  quite  inelastic;  cutting  wages  may  
just  make  firms  more  profitable.  
6.  Regional  grants  

These  can  help  overcome  geographical  unemployment  by  encouraging  firms  to  
set  up  in  depressed  areas,  or  helping  workers  to  move  to  areas  of  high  demand.  

• However,  subsidies  may  prove  ineffective  for  encouraging  workers  to  

move,  because  they  may  be  attached  to  their  local  community.  Also,  firms  
may  have  a  similar  reluctance  to  set  up  in  depressed  areas  because  of  a  
lack  of  infrastructure.  

44  
 
 The  Phillips  curve  
The  Phillips  curve  suggests  that  we  can  often  see  a  trade-­‐off  between  
unemployment  and  inflation.  

 
• If  the  government  increased  spending  (G),  we  would  see  an  increase  in  
AD.  This  leads  to  a  rise  in  real  GDP  (Y1  to  Y2).    
• As  output  rises,  firms  will  hire  more  workers,  and  unemployment  falls.  
• But  as  the  economy  gets  closer  to  full  capacity  (positive  output  gap),  we  
start  to  see  inflationary  pressures  (P1  to  P2).  

Short-­‐run  Phillips  Curve  

 

 
Therefore,  after  a  rise  in  AD  we  go  from  (A)  -­‐  unemployment  (6%)  and  low  inflation  
(2%),  and  move  to  point  (B)  -­‐  unemployment  (3%)  and  higher  inflation  (5%).  

45  
 
Monetarist  view  of  long  run  Phillips  Curve  (LRPC)  
This  monetarist  model  suggests  there  will  only  be  a  temporary  trade-­‐off  between  
unemployment  and  inflation.  

 
• In  this  model,  the  long-­‐run  Phillips  curve  gives  a  natural  unemployment  
rate  of  6%.    
• Initially,  we  assume  workers  expect  inflation  of  2%.  
• If  there  is  an  increase  in  AD,  we  get  a  temporary  fall  in  unemployment  to  
4%  (point  B).  At  B,  there  is  a  positive  output  gap.  
• However,  when  inflation  expectations  adjust,  the  short-­‐run  Phillips  Curve  
(SRPC)  shifts  to  the  right.  
• The  economy  returns  to  full  employment,  we  move  back  to  point  C  at  6%  
unemployment,  but  at  a  higher  price  level  (3.5%),  and  higher  inflation  
expectations.  
• To  reduce  unemployment  below  the  natural  rate,  we  have  to  allow  an  
ever-­‐accelerating  rate  of  inflation.  The  natural  rate  is  sometimes  known  
as  the  non-­‐accelerating  rate  of  unemployment.  

Importance  of  the  Phillips  Curve  

• If  the  Monetarist  view  is  correct,  it  would  suggest  that  demand-­‐side  
policies  to  reduce  unemployment  will  be  ineffective  in  the  long  run.  
Therefore,  Monetarists  place  greater  stress  on  supply-­‐side  policies.  
• If  the  Keynesian  view  of  the  Phillips  Curve  is  correct,  then  demand-­‐side  
policies  could  play  a  role  in  reducing  cyclical  unemployment.  However,  
they  would  still  have  to  be  careful  not  to  cause  inflation.  
• L-­‐shaped  curve.  In  some  situations,  e.g.  deep  recession,  it  is  possible  to  
reduce  unemployment  without  inflation.  However,  when  the  economy  
gets  close  to  full  capacity,  reducing  unemployment  has  a  much  bigger  
impact  on  inflation.  

46  
 
Avoiding  conflict  between  inflation  and  unemployment  
1.  Supply-­‐side  policies  to  reduce  structural  unemployment.  

If  the  government  introduced  successful  supply-­‐side  policies,  we  could  see  a  fall  
in  structural  and  frictional  unemployment.  This  would  reduce  the  natural  rate  of  
unemployment  and  shift  the  Phillips  curve  to  the  left.  

 
There  is  still  a  trade-­‐off  between  unemployment  and  inflation,  but  after  
the  fall  in  the  natural  rate  of  unemployment  there  is  a  better  trade-­‐off.  
2.  Economic  growth  close  to  long-­‐run  trend  rate  of  growth.  
If  the  economic  growth  is  kept  close  to  the  long-­‐run  trend  rate  (e.g.  2.5%),  then  
the  growth  is  sustainable.  In  this  case  there  will  not  be  a  positive  output  gap,  but  
we  will  reach  full  employment  with  minimal  inflationary  pressure.  

47  
 
 Inflation  and  deflation  
• Inflation.  This  means  a  sustained  increase  in  the  general  price  level.  If  
there  is  inflation,  the  value  of  money  declines  and  there  is  an  increase  in  
the  cost  of  living.  
• Deflation.  This  means  there  is  a  fall  in  the  price  level  (negative  inflation  
rate).  
• Disinflation.  This  means  there  is  a  falling  inflation  rate  —  prices  are  
increasing  at  a  slower  rate.  
• Hyperinflation.  A  very  high  and  accelerating  inflation  rate.  Usually  
inflation  rate  of  over  500%  -­‐  where  price  increases  become  out  of  control.  
UK  has  never  experienced  inflation  over  30%  since  1900.  
• Inflation  target.  In  the  UK,  the  government  has  set  an  inflation  target  of  
CPI  =  2%  +/-­‐  1.  The  Bank  of  England  tries  to  achieve  this  target.  

 
• This  shows  the  monthly  CPI  inflation  rate  compared  to  the  government’s  
target  of  2%.  
• Between  1990  and  1993,  we  see  a  fall  in  the  inflation  rate  (from  8%  to  
2%).  This  means  that  in  this  period,  prices  increased  at  a  slower  rate.  

 
 

48  
 
Measuring  inflation    
The  main  method  of  calculating  inflation  in  the  UK  is  the  Consumer  Price  Index        
(CPI).  This  is  calculated  through  different  steps.  

• Household  expenditure  survey.  This  seeks  to  measure  what  people  

spend  their  money  on.  From  this  we  get  a  typical  basket  of  the  1000  most  
popular  goods  and  services.  The  basket  of  goods  is  updated  each  year  to  
take  into  account  changes  in  expenditure.  
• Weighting  of  different  goods.  The  goods  and  services  in  the  inflation  
index  are  given  a  weighting  depending  on  what  percentage  of  spending  
they  generate.  For  example,  petrol  may  have  a  weighting  of  5%  of  the  
total  basket  of  goods.  Bus  travel  will  have  a  lower  weighting  of,  say,  0.4%.  
• Price  changes.  Every  month,  changes  in  the  prices  of  goods  and  services  
are  measured.  The  price  changes  are  then  multiplied  by  their  weighting  
and  combined  into  a  single  index  figure  that  shows  the  percentage  change.    
• Index.  The  price  rises  are  converted  into  an  index.  This  has  a  base  year  of  
100,  and  enables  percentage  comparisons  to  be  made.  
 

Problems  with  calculating  CPI    

• The  expenditure  survey  does  not  include  everybody,  e.g.  pensioners  are  
excluded,  but  pensioners  have  different  spending  habits,  e.g.  heating  is  
more  important.  Young  people  will  benefit  more  from  the  falling  prices  of  
mobile  phones.  
• Changes  in  quality:  Computers  have  many  more  features  than  10  years  
ago,  so  it  is  difficult  to  compare  prices  because  they  are  different  goods.  
• CPI  ignores  some  housing  costs.    
• It  is  impossible  to  measure  all  prices  in  the  economy.  In  modern  
economies,  the  types  of  goods  and  services  used  are  constantly  changing;  
the  CPI  cannot  keep  up  with  all  the  trends  and  new  types  of  goods.  

Retail  price  index  (RPI)  

• The  RPI  is  another  measure  of  inflation.  It  is  similar  to  CPI,  but  includes  
more  factors.  
• RPI  includes  the  cost  of  mortgage  interest  payments.  This  can  make  RPI  
more  volatile.    For  example,  if  interest  rates  rise,  we  will  see  RPI  inflation  
increase  more  than  CPI,  because  mortgages  are  more  expensive.  

Core  inflation  
• Core  inflation  measures  the  underlying  rate  of  inflation,  excluding  volatile  
factors  like  raw  material  prices,  and  taxes.  
• A  rise  in  oil  prices  would  cause  higher  CPI  inflation,  but  the  core  inflation  
would  be  more  stable.  
 

49  
 
Effects  and  costs  of  inflation  
If  inflation  is  high  (above  the  government’s  target),  we  can  have  several  negative  
impacts  on  the  economy.  
On  consumers  

• Fall  in  the  value  of  savings.  Consumers  who  have  cash  savings  will  see  a  
fall  in  the  real  value  of  their  savings.  If  inflation  is  higher  than  interest  
rates,  savings  will  decrease  in  value.  
• Fall  in  the  value  of  debt.  High  inflation  will  reduce  the  value  of  debt,  
making  it  easier  for  consumers  and  firms  to  pay  back  their  debt.  With  
high  inflation,  borrowers  are  likely  to  become  better-­‐off,  and  lenders  are  
likely  to  become  worse-­‐off.  
• Fall  in  real  wages.  High  inflation  could  be  damaging  to  workers.  If  
inflation  is  higher  than  the  growth  of  nominal  wages,  real  wages  will  fall.  
In  periods  of  high  inflation,  workers  will  need  to  bargain  for  higher  
nominal  wages  to  maintain  their  real  incomes.  

 
Between  2001  and  2008,  wages  grew  at  a  faster  rate  than  CPI  inflation.  Therefore,  
real  wages  were  rising.  Since  2008,  wages  have  been  mostly  growing  at  a  slower  
rate  than  inflation,  and  therefore,  real  wages  were  falling.  

• Exam  tip:  Inflation  doesn’t  mean  people  automatically  buy  less.  Inflation  
could  be  caused  by  rising  demand,  where  people  are  spending  more.    
• However,  inflation  could  cause  less  spending  if  the  prices  are  rising  faster  
than  wages.  

50  
 
Effects  of  inflation  on  firms  

• Uncertainty.  High  inflation  may  create  uncertainty  and  confusion  for  

firms.  In  periods  of  high  inflation,  firms  may  be  less  willing  to  invest  
because  they  don’t  know  what  their  future  costs  and  incomes  will  be.  Less  
investment  can  reduce  the  rate  of  economic  growth.  
• Menu  costs.  High  inflation  can  create  menu  costs,  which  means  firms  
have  to  adjust  price  lists.  Firms  and  consumers  may  also  spend  more  time  
checking  prices.  
Effect  of  inflation  on  economy  

• Less  investment.  If  inflation  is  high,  it  can  creates  uncertainty  about  
future  costs  and  therefore  firms  are  likely  to  reduce  investment,  leading  
to  lower  economic  growth.  It  is  argued  that  periods  of  low  inflation  are  
beneficial  for  promoting  investment  and  sustainable  economic  growth.  
• Decline  in  competitiveness.  Relatively  higher  inflation  in  the  UK  can  
make  UK  firms  less  competitive,  leading  to  lower  exports  and  
deterioration  in  the  current  account.  
• Higher  interest  rates.  Governments  may  be  concerned  about  inflation  
because  of  the  uncertainty  and  potential  for  declining  living  standards.  
The  Central  Bank  (or  the  government)  may  feel  the  need  to  increase  
interest  rates.  Higher  interest  rates  can  reduce  inflation,  but  at  the  cost  of  
lower  economic  growth,  and  a  boom-­‐and-­‐bust  economy.  

Problems  of  deflation  

If  prices  fall,  this  can  also  cause  problems  for  the  economy.  

51  
 
 • Less  spending.  Falling  prices  may  deter  people  from  buying  goods  (they  
wait  for  them  to  be  cheaper  later);  this  leads  to  lower  aggregate  demand.  
• Higher  real  debt  burden.  If  prices  and  wages  are  falling,  then  deflation  
causes  the  real  value  of  debt  to  increase.  Debt  repayments  will  become  a  
bigger  percentage  of  income.  This  gives  consumers  less  disposable  
income  and  can  cause  lower  AD.  
• Monetary  policy  becomes  ineffective.  Interest  rates  cannot  fall  below  
0%.  If  we  have  deflation,  real  interest  rates  effectively  increase.  Deflation  
can  become  difficult  for  Central  Banks  to  solve.  
• Government  debt  as  a  %  of  GDP  likely  to  rise.  Deflation  can  make  it  
more  difficult  for  the  government  to  reduce  debt  to  GDP  ratios.  
• Real-­‐wage  unemployment.  If  prices  fall,  but  wages  stay  the  same  ‘sticky  
wages’,  it  will  cause  real-­‐wage  unemployment.  Workers  often  resist  
nominal  wage  cuts  because  no  one  likes  to  see  their  wages  actually  cut.  

Causes  of  deflation  

1) Falling  aggregate  demand.  If  there  is  a  sharp  fall  in  AD,  falling  output  
and  a  rise  in  unemployment,  then  this  can  lead  to  lower  prices  and  lower  
wages.  
2) Rising  productivity.  If  deflation  is  caused  by  a  fall  in  costs  and  rising  
productivity,  then  deflation  may  not  be  damaging  to  the  economy.  This  
kind  of  deflation  can  also  cause  rising  real  GDP.  

 
• This  shows  deflation  caused  by  SRAS  shifting  to  the  right,  but  it  also  
enables  higher  real  GDP.  
• Another  potential  benefit  of  deflation  is  that  your  economy  may  become  
more  internationally  competitive,  and  it  could  lead  to  rising  exports.  It  
depends  whether  other  countries  are  also  experiencing  deflation.  

52  
 
Causes  of  inflation  
1.  Demand-­‐pull  inflation  

• If  aggregate  demand  (AD)  rises  faster  than  aggregate  supply  (AS),  then  we  
will  get  inflation.  
• Demand-­‐pull  inflation  occurs  if  the  economic  growth  is  too  fast,  e.g.  if  the  
growth  is  above  the  long-­‐run  trend  rate.  

 
As  the  economy  reaches  full  capacity,  rising  AD  leads  to  more  inflation.  Demand-­‐
pull  inflation  could  occur  due  to  various  factors.  For  example:  

• Lower  interest  rates.  A  cut  in  interest  rates  reduces  the  cost  of  borrowing,  
encouraging  spending  and  investment.  
• Rising  house  prices,  which  increases  consumers’  wealth  and  confidence.  
• Boom  in  exports  from  a  rising  global  demand,  e.g.  strong  growth  in  
Europe.  
• Income  tax  cut,  which  gives  consumers  more  disposable  income  to  spend.  
• A  rapid  rise  in  the  money  supply,  e.g.  the  Central  Bank  printing  more  
money.  
• The  UK  experienced  demand  pull  inflation  in  the  late  1980s,  due  to  rapid  
economic  growth  of  5%.  This  growth  proved  unsustainable.  

53  
 
2.  Cost-­‐push  inflation  
This  occurs  when  there  is  a  rise  in  the  costs  of  firms,  leading  to  short-­‐run  
aggregate  supply  (SRAS)  shifting  to  the  left.  

 
Cost-­‐push  inflation  could  occur  due  to:  

• Rising  oil  prices/  raw  material  prices.  This  would  increase  the  costs  of  
most  firms,  due  to  higher  transport  costs.  
• Rising  wages.  If  wages  are  pushed  higher  by  trade  unions  or  a  shortage  
of  workers,  this  will  increase  the  costs  of  firms.  (Rising  wages  may  also  
cause  demand-­‐pull  inflation  as  consumers  spend  more,  increasing  AD.)  
• Import  prices.  One  third  of  all  goods  are  imported  in  the  UK.  If  there  is  a  
depreciation  in  the  exchange  rate,  then  import  prices  will  become  more  
expensive,  leading  to  an  increase  in  inflation.  
• In  2011,  the  UK  had  cost-­‐push  inflation  of  5%  despite  a  lengthy  recession.  
The  inflation  in  2011  was  caused  by  higher  taxes,  depreciation  in  the  
pound,  and  higher  raw  material/food  prices.  

Effect  of  a  devaluation  in  the  exchange  rate  on  inflation  

If  the  exchange  rate  falls  in  value,  it  tends  to  cause  inflation  for  three  reasons.  
1. Higher  AD.  Cheaper  exports  increase  export  demand.  More  expensive  
imports  reduce  import  spending  and  encourage  consumers  to  buy  from  
UK  firms.  Therefore,  we  see  a  rise  in  AD.  
2. Imports  are  more  expensive.  Many  goods  are  imported;  after  a  
devaluation,  they  will  be  more  expensive.  
3. Less  incentive  to  cut  costs.  A  devaluation  makes  firms  cheaper  without  
much  effort  so  that  they  may  have  less  incentive  to  cut  costs.  

54  
 
Quantity  theory  of  money  
Monetarists  argue  that  a  key  factor  in  determining  inflation  is  the  growth  of  the  
money  supply.  If  the  money  supply  grows  faster  than  the  rate  of  growth  of  real  
income,  there  will  be  inflation.  
Fisher  equation  of  exchange  MV  =  PT  

• M  =  money  supply.  The  stock  of  money  (cash  +  bank  deposits)  

• V  =  velocity  of  circulation.  The  number  of  times  money  changes  hands  
• P  =  price  level  
• T  =  Transactions  

Therefore,  PT  =  nominal  national  expenditure.  

Explaining  the  quantity  theory  of  money  

• Monetarists  believe  that  in  the  short  term,  velocity  (V)  is  fixed.  
• Monetarists  also  believe  output  Y  is  determined  by  supply-­‐side  factors.    
• Therefore,  an  increase  in  the  money  supply  (M)  faster  than  the  growth  of  
national  income  will  lead  to  an  increase  in  (P)  inflation.  

 
• If  there  is  an  increase  in  the  money  supply,  consumers  have  more  money  
to  spend,  so  AD  shifts  to  the  right  (AD2).  This  causes  an  increase  in  real  
GDP  and  higher  inflation.  
• Firms  pay  higher  wages  to  workers  so  that  they  will  do  overtime.  

55  
 
 • Initially,  with  low  inflation  expectations,  workers  see  the  nominal  wage  
increase  as  a  real  increase,  therefore  they  do  work  more.  
• However,  this  positive  output  gap  is  not  sustainable.  Workers  don’t  want  
to  keep  doing  overtime  permanently.  Also,  when  workers  see  inflation  
has  increased,  they  realise  real  wages  have  stayed  the  same  and  so  they  
don’t  want  to  do  overtime.  
• With  higher  nominal  wages,  SRAS  shifts  to  the  left.  
• This  shift  in  the  SRAS  causes  inflation  to  increase  and  real  GDP  to  return  
to  Y1  —  the  full  employment  level  of  real  GDP,  but  now  at  a  higher  price  
level  (P3).  
• Therefore,  in  this  model,  the  increase  in  the  money  supply  has  not  
changed  real  GDP  in  the  long  run,  but  it  has  caused  a  higher  price  level.  

Criticisms  of  the  monetarist  view  on  inflation  

• Money  supply  link  to  inflation  is  weak.  Evidence  in  the  1980s  showed  
that  the  money  supply  could  grow  much  faster  than  the  price  level,  
suggesting  the  link  was  not  true  in  the  real  world.  
• Quantitative  easing  did  not  cause  inflation.  In  the  great  recession  of  
2008-­‐13,  even  quantitative  easing  (increasing  monetary  base)  didn’t  lead  
to  higher  inflation,  because  the  economy  was  depressed.  
• The  velocity  of  circulation  (V)  is  not  stable.  The  velocity  of  circulation  
can  change  due  to  factors  such  as  an  increase  in  the  use  of  credit  cards.  
Growth  in  the  money  supply  can  be  erratic  and  due  to  institutional  factors,  
e.g.  more  cash  machines  caused  an  increase  in  M0.  
• Economy  not  always  at  full  employment.  Keynesians  argue  that  the  
LRAS  is  not  necessarily  inelastic;  they  argue  that  the  economy  can  be  
below  full  capacity  for  a  long  time.  In  this  depressed  state,  increasing  the  
money  supply  may  not  cause  inflation.  
 

Importance  of  inflation  expectations  

If  people  expect  low  inflation,  low  inflation  is  more  likely  to  occur.    

• If  workers  expect  low  inflation,  they  will  be  more  likely  to  accept  low  
wage  increases.  
• If  firms  expect  low  inflation  and  low  cost  of  raw  materials,  they  will  keep  
prices  competitive.  
• If  inflation  expectations  rise,  it  can  cause  inflation  —  as  firms  push  up  
prices,  and  workers  try  to  secure  higher  wages.  
• In  the  1970s,  the  UK  experienced  high  inflation.  This  was  partly  caused  by  
rising  oil  prices,  but  also  by  strong  wage  growth.  Trade  unions  bargained  
for  higher  wages  because  they  expected  inflation.  
• If  a  Central  Bank  has  strong  anti-­‐inflation  credibility,  it  can  make  it  easier  
to  keep  inflation  low.  This  is  why  many  governments  gave  the  
responsibility  of  monetary  policy  to  an  independent  Central  Bank.  

56  
 
 Income  distribution  and  welfare  
Income  and  wealth    
• Wealth  is  a  stock  concept;  it  is  the  value  of  assets,  such  as  savings,  housing,  
and  shares.  Wealth  inequality  refers  to  different  amounts  of  assets  people  
in  society  may  have.  
• Income  is  the  amount  of  money  a  person  receives  per  time  period,  e.g.  
salary.  Income  inequality  refers  to  variations  in  income  levels  (e.g.  
relatively  different  wages).  

Causes  of  income  inequality  

1. Inequality  in  wages  and  earnings  growth.  Workers  with  high  levels  of  
skills  will  be  able  to  gain  higher  wages.  However,  those  with  few  skills  or  
qualifications  will  find  themselves  unemployed  or  in  low  paid  jobs.    
2. Unemployment.  High  levels  of  structural  and  long-­‐term  unemployment  
are  one  of  the  biggest  causes  of  poverty  in  the  UK  because  the  
unemployed  rely  on  government  benefits,  which  are  substantially  less  
than  wages.  
3. Monopsony  /  monopoly.  A  powerful  firm  with  monopsony  power  can  
pay  low  wages  to  workers  and  keep  high  profits  for  shareholders.  

Causes  of  wealth  inequality  

• Opportunity  to  save.  Those  with  low  income  do  not  have  any  disposable  
income  to  save  and  increase  wealth.  High  income  earners  may  have  
substantial  spare  cash.  
• Rent  and  accumulation.  Those  who  are  wealthy  (e.g.  own  a  house)  can  
gain  rentable  income,  which  they  can  use  to  invest  in  the  accumulation  of  
more  assets.  
• Inheritance.  Wealth  can  be  inherited,  income  cannot.  
• Tax.  Taxes  on  income  tend  to  be  higher  than  taxes  on  wealth.  

Is  inequality  necessary?  
• Incentives  play  an  important  role  in  a  free  market.  People  need  incentives  
to  take  risks  and  make  the  effort  of  setting  up  a  business.    
• Without  the  prospect  of  higher  income,  enterprise  would  be  limited.  
Therefore  a  degree  of  inequality  is  needed  in  a  free  market  economy.  
• Policies  to  reduce  inequality  may  create  disincentives  to  work,  e.g.  higher  
income  tax  may  discourage  working  overtime.  Benefits  to  the  
unemployed  /  low  paid  can  discourage  taking  work  (unemployment  trap  
/  poverty  trap).  

57  
 
Problems  of  inequality  
• Exploitation.  The  wealthy  can  exploit  their  monopoly  power  to  make  
higher  profits  at  the  expense  of  others,  e.g.  landlords  have  a  degree  of  
monopoly  power  in  setting  rents,  especially  in  places  like  London.  
• Social  friction.  High  levels  of  inequality  can  cause  social  friction  and  
resentment  in  society.  
• Diminishing  marginal  utility  of  money.  Taking  more  tax  from  high-­‐
income  earners  has  little  impact  on  living  standards,  taking  tax  from  low  
earners  has  a  greater  impact  because  they  have  to  cut  back  on  essentials.  

Poverty    
• Absolute  poverty.  This  measures  the  number  of  people  living  below  a  
certain  income  level  which  is  necessary  to  be  able  to  afford  basic  goods  and  
services.  
• Relative  poverty.  This  occurs  when  the  income  of  a  household  is  low  
compared  to  others,  e.g.  one  definition  of  relative  poverty  is  when  a  person  
has  income  below  50%  of  the  national  average.  

Measuring  Poverty  
The  Lorenz  curve.  This  measures  the  degree  of  income  inequality.  The  further  
the  Lorenz  curve  is  from  the  45  degree  line  of  perfect  equality,  the  more  
inequality  there  is  in  society.  
 

In  this  diagram  the  

poorest  50%  of  the  
population  have  27%  
of  total  income.    
This  means  the  
richest  50%  have  
73%  of  total  income.  

 
2.  Gini  Coefficient  This  is  a  measure  of  inequality  based  on  the  Lorenz  curve:  

58  
 
 • The  Gini  coefficient  is  area  a  /  a+b.  
• The  bigger  area  ‘a’  is,  the  more  inequality  exists.  
• A  Gini  coefficient  of  0  =  perfect  equality.  
• A  Gini  coefficient  of  1.00  =  perfect  inequality.  
In  the  1980s,  the  UK  saw  a  significant  rise  in  income  inequality,  which  has  been  
maintained  in  the  past  two  decades.  

Causes  of  relative  poverty  /  inequality  

Relative  poverty  can  occur  even  in  rich  countries,  with  high  rates  of  economic  
growth.  It  is  tied  to  inequality  within  society.  The  biggest  causes  of  relative  
poverty  are:  
1. Inequality  in  wages  and  earnings  growth.  Workers  with  high  levels  of  
skills  will  be  able  to  gain  higher  wages.  However,  those  with  few  skills  or  
qualifications  will  find  themselves  unemployed  or  in  low-­‐paid  jobs.  Wage  
inequality  can  be  affected  by  many  things,  including:  
 
• In  the  UK,  de-­‐industrialisation  and  a  shift  to  the  service  sector  has  
increased  demand  for  skilled  workers  but  there  has  been  a  fall  in  the  
number  of  well-­‐paid  unskilled  manual  labour.  
• Globalisation  has  increased  pressure  on  firms  to  cut  costs;  this  often  
involves  reducing  wage  costs  for  the  lowest  pay.  
• Growth  in  part-­‐time  and  temporary  jobs  (e.g.  zero  hour  contracts),  
which  tend  to  be  lower  paid.  
• Decline  of  trades  unions,  and  growth  of  monopsony  power  by  firms,  
leaves  many  workers  unable  to  bargain  for  higher  wages.    
2. Unemployment.  High  levels  of  structural  and  long-­‐term  unemployment  
are  one  of  the  biggest  causes  of  poverty  in  the  UK,  because  the  
unemployed  rely  on  government  benefits,  which  are  substantially  less  
than  wages.  
 
3. Falling  relative  value  of  state  benefits.  If  pensions  and  other  welfare  
benefits  are  index  linked  (increasing  in  line  with  inflation),  then  they  
could  fall  behind  real  wages,  which  usually  rise  faster  than  inflation.  
 
4. Regressive  taxes.  Tax  changes  in  the  1980s  and  1990s  have  put  a  higher  
burden  of  tax  on  the  poor.  There  has  been  a  shift  in  taxes  from  
progressive  income  tax  to  regressive  indirect  taxes,  therefore  causing  an  
increase  in  inequality.  
 

 
 

59  
 
 Fiscal  policy  
Fiscal  policy  is  the  government’s  attempt  to  influence  AD  through  changing  
spending  and  tax  levels.    

• The  aim  of  fiscal  policy  could  be  to:  

1. Stimulate  economic  growth  in  a  period  of  recession.  
2. Maintain  low  inflation  
• Fiscal  policy  can  also  influence  the  supply-­‐side  of  the  economy.    
• For  example,  higher  government  spending  on  education  can  
increase  AD,  but  may  also  help  reduce  structural  unemployment.  
• Fiscal  policy  will  also  affect  the  level  of  government  borrowing.  

Expansionary  fiscal  policy  (loose  fiscal  policy)  

This  involves  lower  tax  rates  and/or  higher  government  spending,  with  the  aim  
to  increase  AD.  

 
• Expansionary  fiscal  policy  will  increase  AD  and  increase  the  size  of  the  
budget  deficit.  It  may  also  cause  inflation,  especially  if  economy  is  close  to  
full  capacity.  
• Expansionary  fiscal  policy  is  likely  to  be  used  during  a  recession,  when  
there  is  negative  economic  growth.  
• In  a  liquidity  trap,  monetary  policy  can  become  ineffective.  In  this  case,  a  
government  may  use  expansionary  fiscal  policy.  
 
 

60  
 
Deflationary  fiscal  policy  (tight  fiscal  policy)    
• This  involves  higher  tax  rates  and/or  lower  government  spending.  
• The  aim  of  deflationary  fiscal  policy  is  to  decrease  AD  and  inflation.  
• Deflationary  fiscal  policy  will  also  improve  the  budget  deficit.  

Evaluation  of  fiscal  policy  

1. Supply-­‐side.  Fiscal  policy  can  also  influence  the  supply-­‐side  of  the  
economy.  For  example,  expansionary  fiscal  policy  which  involves  higher  
government  spending  could  be  targeted  on  education  and  infrastructure  
spending.  If  successful,  this  can  increase  AD,  but  also  increase  productive  
capacity  and  improve  long-­‐run  economic  growth.  
2. Poor  information  may  reduce  the  accuracy  of  forecasting  future  
economic  growth  and  inflation.  Therefore,  the  government  may  be  unsure  
whether  they  need  to  boost  or  reduce  AD.  In  practice,  governments  find  it  
difficult  to  ‘fine-­‐tune’  the  economy  with  fiscal  policy.  But  in  major  
recession,  they  may  try  expansionary  fiscal  policy.  
3. It  depends  on  other  components  of  AD.  For  example,  if  the  government  
cuts  income  tax  to  increase  AD,  it  may  be  ineffective  if  consumer  
confidence  is  low  and  people  just  save  the  extra  income.  
4. Disincentives  to  work.  Higher  income  tax  to  reduce  inflation  can  create  
disincentives  to  work,  reducing  productivity  and  AS.  
5. Time  lag  involved  in  influencing  AD.  If  the  government  wanted  to  
increase  AD,  they  could  commit  to  more  government  spending.  But  there  
will  be  delays  in  actually  implementing  higher  spending,  and  then  delays  
in  this  spending  affecting  the  wider  economy.  

61  
 
 6. Budget  deficits.  Expansionary  fiscal  policy  (higher  spending,  lower  tax)  
will  increase  government  borrowing.  This  could  lead  to  higher  interest  
rates  in  the  long  term,  or  even  cause  markets  to  lose  confidence  in  
government  debt  levels.  
7. Crowding  out.  If  the  government  spends  more  by  borrowing  from  the  
private  sector,  it  may  reduce  the  amount  of  money  the  private  sector  has  
to  spend.    Therefore,  there  is  no  overall  increase  in  AD.  
 
• Financial  crowding  out  –  This  occurs  when  government  borrowing  
pushes  up  interest  rates  and  reduces  investment  due  to  the  higher  
interest  rates.  
• Resource  crowding  out  –  This  occurs  when  government  borrowing  
causes  the  private  sector  to  have  less  money  to  spend  on  investment  
because  the  private  sector  has  used  these  funds  to  lend  to  the  
government.  
 
Evaluation  of  crowding  out  
 
Keynesian  economist  argue  that  crowding  out  doesn’t  always  occur,  e.g.  if  the  
economy  is  in  a  recession  /  liquidity  trap.  In  a  recession,  there  will  be  high  
demand  for  saving  and  therefore  government  borrowing  is  making  use  of  
otherwise  idle  resources.  

Public  expenditure    
Government  spending  includes  all  forms  of  spending  by  central  and  local  
government.  The  main  types  of  government  spending  are:  

• Capital  expenditure.  This  is  government  spending  on  capital  projects  

and  creating  new  assets.  It  is  investment  that  increases  the  capital  stock  
of  the  economy.    
o This  typically  involves  building  new  roads,  railways,  hospitals,  and  
improving  communication.  This  capital  spending  can  increase  the  
productive  capacity  of  the  economy  in  the  future,  because  it  helps  
shift  long-­‐run  aggregate  supply  to  the  right.  
 
• Current  expenditure.  This  is  government  spending  on  items  that  are  
recurring  and  only  lasts  a  limited  time,  e.g.  spending  on  public  sector  
wages  and  consumable  products.  
 
o E.g.  building  a  school  which  lasts  50  years  is  capital  expenditure.  
Paying  teachers’  wages  and  paying  electric  bills  is  current  
spending.  
 
• Transfer  payments.  These  are  simple  payments  from  the  government  to  
individuals.  It  represents  a  redistribution  of  income  in  society.  Examples  
of  transfer  payments  include:  
• Pensions  
• Welfare  payments,  such  as  unemployment  benefit  and  housing  benefit  

62  
 
Levels  of  government  spending  
Real  government  spending  —  Spending  levels  adjusted  for  inflation.  

In  2011/12,  there  was  a  small  fall  in  real  government  spending  due  to  the  policy  of  
austerity  (cutting  government  spending)  

 
Government  spending  as  a  %  of  GDP  rose  from  2000  to  2009  

63  
 
Impact  of  higher  government  spending  
An  increase  in  real  government  spending  could  imply:  

• More  investment  in  education  and  infrastructure.  The  government  

can  use  tax  revenues  to  overcome  market  failure  in  areas  such  as  
transport,  education,  and  health.  Providing  goods  with  positive  
externalities  can  lead  to  greater  social  efficiency.  It  can  also  help  improve  
indices  of  economic  development,  such  as  literacy  rates.  
• Redistribution.  The  government  can  spend  money  to  redistribute  
income  amongst  people  on  low  incomes.  This  can  help  promote  a  more  
equal  society  and  improve  economic  welfare.  Countries  with  the  highest  
levels  of  government  spending  (Norway,  France,  UK)  have  the  most  
developed  welfare  states,  which  provide  a  safety  net  and  healthcare  for  
the  poorer  members  of  society.  
• Fiscal  policy.  In  a  recession,  government  spending  may  be  effective  in  
stimulating  the  economy,  e.g.  government  borrowing  can  offset  a  rise  in  
private  sector  saving,  and  increase  AD.  
• Automatic  stabilisers.  Between  2007  and  2010,  the  increase  in  
government  spending  as  a  %  of  GDP  is  a  consequence  of  the  recession,  
causing  a  fall  in  GDP,  but  higher  government  spending  on  unemployment  
and  housing  benefits.  
 

Evaluation  of  higher  government  spending  

• Higher  taxes  may  be  required  to  fund  higher  spending.  Higher  income  
tax  rates  could  create  disincentives  to  work.  Higher  corporation  tax  could  
discourage  firms  from  setting  up  in  that  country,  leading  to  lower  growth.  
• Potential  inefficiency  of  government  spending.  Often,  government  
bodies  lack  a  profit  incentive  to  be  efficient.  Therefore,  government  
spending  could  be  wasteful,  misused,  and  inefficient.    On  the  other  hand,  it  
could  overcome  market  failure,  e.g.  lack  of  education.  
• Efficiency.  Government  spending  could  become  more  efficient  through  
competitive  tendering  and  public-­‐private  partnerships,  which  involve  
both  public  and  private  sectors.  There  is  no  reason  government  spending  
has  to  be  inefficient.  
• Crowding  out.  An  increase  in  the  government  sector  has  an  opportunity  
cost.  More  government  spending  means  a  decline  in  the  size  of  the  private  
sector  and  a  reduction  in  private  sector  enterprise.  
• Depends  on  the  kind  of  spending.  It  depends  on  what  the  government  
is  spending  the  money:  
o Spending  on  welfare  benefits  (transfer  payments)  may  increase  
equality,  but  be  detrimental  to  efficiency  and  productivity.    
o Spending  on  transport  links  (capital  spending)  can  help  the  
economy  become  more  efficient  and  competitive  in  the  long  term.  

64  
 
Taxation  
• Progressive  tax  occurs  when  those  on  higher  income  levels  pay  a  
higher  %  of  their  income  in  tax,  e.g.  the  UK  has  a  top  rate  of  45%  on  
marginal  income  over  £150,000;  this  is  a  progressive  tax.  
• Regressive  tax  occurs  when  an  increase  in  income  leads  to  a  smaller  %  of  
their  income  going  on  the  tax,  e.g.  excise  duties  and  VAT  take  a  bigger  %  
of  low  income  earners.  
• Proportional  taxation  takes  same  %  of  income,  whatever  income  band.  
• Direct  taxation  is  taken  from  people’s  earnings  directly,  e.g.  income  tax  
and  NI.  
• Indirect  taxation  is  paid  by  firms  selling  goods,  e.g.  VAT  is  included  in  
the  final  price  consumers  pay.  
 

The  requirements  of  a  good  tax  system  

1. Horizontal  equity,  e.g.  those  in  the  same  circumstances  should  pay  the  
same  taxes.  
2. Vertical  equity.  A  degree  of  proportionality  is  important,  e.g.  progressive  
income  tax.  
3. Cheap  to  collect.  
4. Difficult  to  evade.  
5. Efficient,  non-­‐distorting,  e.g.  if  income  taxes  are  too  high,  people  may  be  
put  off  working.  
6. Easy  to  understand.  

65  
 
Reasons  for  tax  
• Raising  revenue  
• Promoting  redistribution  of  income  and  wealth  
• Discouraging  consumption/production  of  goods  with  negative  
externalities  or  demerit  goods  

Impact  of  increasing  the  rate  of  income  tax  

• Higher  revenues.  Higher  income  tax  should  increase  tax  revenues.  
The  government  can  spend  more  on  public  services  and  benefits  to  
reduce  inequality  and  fund  capital  investment.  
• Tax  evasion.  Higher  income  tax  may  encourage  tax  evasion,  e.g.  
higher  rates  of  income  tax  could  encourage  people  to  work  in  another  
country.  Therefore,  an  increase  in  tax  revenues  may  be  less  than  
expected.  
• Incentives  to  work.  Higher  marginal  tax  rates  may  reduce  incentives  
to  work  and  do  overtime.  The  substitution  effect  states  higher  income  
tax  will  make  work  relatively  less  attractive.  
• Redistribution.  Higher  rates  of  income  tax  can  help  redistribute  
income  from  high  earners  to  low  earners  and  create  more  equality.  
• Aggregate  demand.  Higher  tax  rates  will  reduce  disposable  income  
and  lead  to  lower  consumer  spending.  Ceteris  paribus,  this  could  lead  
to  lower  economic  growth  and  lower  inflation.  

Evaluation  of  higher  income  taxes  

• Disincentives?  Some  fear  higher  income  tax  rates  could  create  
disincentives  to  work.  But  other  economists  suggest  evidence  is  mixed.  
The  substitution  effect  of  a  tax  rise  may  make  people  work  less,  but  the  
income  effect  encourages  them  to  work  more  (to  achieve  target  income).  
• It  depends  how  tax  revenue  is  used.  If  income  tax  revenue  is  invested  in  
improved  infrastructure,  it  can  the  benefit  long-­‐run  productive  capacity.  If  
income  tax  revenue  is  needed  for  welfare  payments,  there  will  be  no  
increase  in  productive  capacity.  
• Does  revenue  increase?  The  Laffer  curve  suggests  there  comes  a  point  
where  higher  income  tax  rates  leads  to  a  decline  in  tax  revenue,  because  
people  stop  working  if  tax  is  too  high.  

Flat  tax  rate  

A  flat  tax  rate  means  there  is  one  single,  unified  income  tax  rate,  e.g.  20%  and  
getting  rid  of  tax  allowances,  and  higher  tax  bands  (e.g.  40%  marginal  tax  rate  for  
incomes  over  £40,000).  

• Advantages  of  flat  tax  include:  simplicity,  easily  understood,  and  less  
disincentives  to  work.  
• A  disadvantage  of  flat  tax  is  less  redistribution  from  high  income  earners.  

66  
 
 Government  borrowing  
 
• The  budget  deficit  is  the  annual  amount  the  government  needs  to  borrow  
from  the  private  sector.    It  is  the  difference  between  government  spending  
(G)  and  tax  revenue  (T).    
• A  budget  surplus  occurs  if  government  spending  is  less  than  tax  revenue.  
• A  balanced  budget  occurs  if  government  spending  equals  tax  revenue.  
• Fiscal  stance  refers  to  the  budget  position,  e.g.  deficit  or  surplus.  
• Primary  budget  balance  refers  to  budget  position  ignoring  interest  
payments.  The  primary  deficit  includes  just  current  expenditure  and  current  
tax  revenues.    
• The  overall  budget  includes  interest  payments  and  all  types  of  spending.  
Financing  the  deficit  

• The  budget  deficit  is  financed  by  the  government  selling  bonds  to  the  private  
sector.  The  government  pays  interest  to  encourage  investors  to  buy  
government  bonds.  
• In  rare  circumstances,  the  Central  Bank  may  create  money  electronically  and  
hold  government  debt  itself.  This  occurred  in  great  recession  of  2009-­‐13.  

• In  2000/01,  the  government  ran  a  budget  surplus  (3.9%  of  GDP).  

• Borrowing  peaked  in  2009-­‐10  (11%  of  GDP)  because  of  the  financial  crisis  and  
recession.  In  2009,  the  government  also  pursued  expansionary  fiscal  policy  
(cutting  VAT  rates  to  boost  AD).  

67  
 
Cyclical  deficit  
During  a  recession,  it  is  likely  that  we  will  see  a  rise  in  government  borrowing,  
due  to  cyclical  factors.  
1. With  lower  growth,  tax  revenues  will  be  lower.  If  people  earn  less,  they  
will  pay  less  income  tax.  With  less  spending,  receipts  from  VAT  will  fall.  
2. In  a  recession,  the  government  will  need  to  spend  more  on  
unemployment  benefits  and  income  support  benefits.  
Structural  deficit    

This  refers  to  a  budget  deficit,  even  if  we  ignore  cyclical  factors.  If  the  
government  has  a  budget  deficit  when  the  economy  is  growing  at  its  long-­‐run  
trend  rate,  this  shows  the  underlying,  structural  deficit.  
Automatic  fiscal  stabilisers  

• This  refers  to  how  tax  rates  and  government  spending  automatically  have  
an  influence  on  the  rate  of  economic  growth  and  help  to  counter  swings  in  
the  economic  cycle.    
• For  example,  in  a  period  of  high  economic  growth,  automatic  stabilisers  
will  help  to  reduce  the  growth  rate.    
• With  higher  growth,  the  government  will  receive  more  tax  revenues  from  
the  same  tax  rates,  people  earn  more  and  so  pay  more  income  tax.  
• With  higher  growth,  there  will  also  be  a  fall  in  unemployment,  so  the  
government  will  spend  less  on  unemployment  and  income  support  
benefits.  
Discretionary  fiscal  policy  

• This  is  a  deliberate  effort  by  the  government  to  influence  aggregate  
demand  and  the  rate  of  economic  growth.  
• For  example,  expansionary  fiscal  policy  involves  a  cut  in  tax  rates  and/or  
higher  government  spending.  

Factors  influencing  the  size  of  the  budget  deficit  

• State  of  economy.  A  booming  economy  will  help  reduce  the  deficit  
through  improving  tax  receipts  and  less  need  for  welfare  payments.  
• Government  spending  decision.  If  the  government  wanted  to  spend  
more  on  health/education  without  increasing  taxes,  this  would  cause  a  
deficit.  
• Fiscal  policy.  If  a  government  pursued  expansionary  fiscal  policy,  it  will    
cause  a  budget  deficit,  at  least  in  the  short  run.  
• Demographics.  If  a  country  has  an  ageing  population,  this  will  cause  a  
higher  demand  on  pension  spending  and  healthcare.  This  may  cause  a  rise  
in  borrowing,  to  finance  this  rise  in  automatic  spending.  
• Rules  on  borrowing  levels.  Countries  in  the  Eurozone  are  obliged  to  
meet  certain  criteria  to  keep  structural  borrowing  less  than  3%  of  GDP.  
However,  these  are  not  always  met.  

68  
 
Economic  effects  of  higher  government  borrowing  
• Higher  debt  interest  payments.  To  finance  the  budget  deficit,  the  
government  will  have  to  sell  more  bonds.  This  increases  the  annual  debt  
interest  payments;  therefore,  future  generations  may  have  to  pay  higher  
taxes  to  pay  these  debt  interest  obligations.  
• Increased  aggregate  demand  (AD).  A  budget  deficit  implies  lower  taxes  
and  increased  government  spending;  ceteris  paribus,  this  will  increase  AD  
and  may  cause  higher  real  GDP  and  inflation.  
• Higher  taxes  and  lower  spending.  In  the  future,  the  government  may  have  
to  increase  taxes  or  cut  spending  in  order  to  reduce  the  deficit.  Higher  taxes  
may  cause  reduced  incentives  to  work.  
• Increased  interest  rates.  If  the  government  needs  to  sell  more  bonds,  this  
could  cause  interest  rates  to  increase.  This  is  because  they  will  need  to  
increase  interest  rates  in  order  to  attract  investors  to  buy  the  extra  debt.  If  
government  interest  rates  increase,  this  will  push  up  other  interest  rates  as  
well.    
o This  may  not  always  occur.    For  example,  in  the  liquidity  trap  (2008-­‐14),  
the  demand  for  government  bonds  was  high  and  interest  rates  fell,  
despite  higher  borrowing  levels.  
• Crowding  out.  Increased  government  spending  to  increase  AD  may  cause  a  
corresponding  decrease  in  the  size  of  the  private  sector  because  of  crowding  
out.  
o However,  if  the  economy  is  depressed  and  the  private  sector  wants  to  
save,  government  borrowing  may  not  cause  crowding  out,  because  the  
government  is  using  money  which  otherwise  would  just  be  saved.  
• Loss  of  confidence.  Countries  with  high  levels  of  government  borrowing  
may  struggle  to  attract  foreign  investors,  e.g.  some  southern  Eurozone  
economies.  
 

Advantages  of  government  borrowing  

Government  borrowing  can  be  beneficial  under  certain  conditions.  
 
1.  Recession.  If  there  is  a  downturn  in  the  economy,  there  will  automatically  be  
a  fall  in  taxation  and  higher  government  spending  on  benefits,  which  will  cause  a  
budget  deficit.    
• If  the  government  attempted  to  solve  the  budget  deficit  by  increasing  
the  rate  of  taxes,  this  would  further  deflate  the  economy,  leading  to  
lower  growth  and  more  unemployment.    
• In  a  recession,  a  government  deficit  is  necessary  to  offset  the  rise  in  
private  sector  saving  and  to  try  and  increase  AD  and,  hence,  improve  
economic  growth.  
• In  a  recession,  the  private  sector  wants  to  save  more,  so  there  is  
usually  a  high  demand  for  government  bonds.    
• By  borrowing,  the  government  is  compensating  for  the  rapid  rise  in  
private  sector  saving  and  therefore  helping  to  make  use  of  
unemployed  resources.  

69  
 
  
2.  Investment.  If  the  government  borrows  to  increase  spending  on  
infrastructure,  such  as  better  roads,  this  can  increase  productivity  and  enable  a  
higher  rate  of  economic  growth  and  more  tax  revenues  in  the  future.  
 

• However,  government  spending  may  not  necessarily  increase  

productivity.  Some  argue  that  government  spending  is  generally  less  
efficient  than  leaving  it  to  the  free  market.    
 
3.  Bailout  key  industries.  In  the  case  of  the  banking  sector,  the  government  
thought  it  necessary  to  bailout  banks,  to  prevent  them  from  going  bankrupt  and  
causing  a  possible  loss  of  confidence  in  the  banking  system.    

The  National  Debt  

• National  debt  /  government  debt  is  the  total  (cumulative)  amount  of  
debt  that  the  government  owes  the  private  sector.    
• It  is  measured  using  Public  sector  net  debt  (PSND).    
 

 
 
In  January  2015,  the  net  debt  was  £1,483.3 billion, equating to 80%  of  GDP.  
 
• UK  national  debt  as  a  %  of  GDP  peaked  after  the  First  and  Second  World  
Wars.  It  fell  during  the  post-­‐war  period,  as  economic  growth  led  to  higher  
GDP,  making  debt  a  smaller  percentage.  
• Net  debt  has  increased  since  the  financial  crisis  of  2007.  
 
 

70  
 
 Monetary  policy  
Monetary  policy  involves  changing  the  interest  rate  or  manipulation  of  the  
money  supply  by  the  monetary  authorities.  

• In  the  UK  monetary  policy  is  managed  by  the  Bank  of  England’s,  Monetary  
Policy  Committee  (MPC).  

Aims  of  monetary  policy  

1. Control  the  rate  of  inflation.  Inflation  target  for  MPC  is  CPI  -­‐  2.0%  +/-­‐1  
2. Maintain  sustainable  economic  growth/low  unemployment  
3. Influence  the  exchange  rate  (not  so  important)  

UK  monetary  policy  
• Every  month,  the  MPC  meets  to  decide  future  interest  rates.    
• If  they  feel  the  inflation  rate  is  likely  to  go  above  the  target  (e.g.  due  to  a  
higher  rate  of  economic  growth),  then  they  will  increase  interest  rates  to  
moderate  demand  and  keep  inflation  low.  
• If  the  MPC  feels  that  inflation  is  likely  to  fall  below  the  target  and  there  is  
slow  economic  growth,  they  are  likely  to  decrease  interest  rates  to  boost  
economic  growth.  
To  determine  future  inflation,  the  MPC  will  look  at  various  statistics,  such  as:  

• The  rate  of  economic  growth  compared  to  the  long-­‐run  trend  rate.  If  the  
growth  is  faster  than  the  trend  rate,  inflation  is  likely  to  occur.  
• Wage  growth.  Higher  wage  growth  can  cause  both  cost-­‐push  and  
demand-­‐pull  inflation.  
• Temporary  factors  like  tax  rises  and  commodity  price  rises  may  be  given  
less  importance  because  they  do  not  indicate  underlying  inflation.  
• Unemployment.  High  unemployment  will  tend  to  reduce  wage  inflation  
and  so  the  MPC  is  more  likely  to  cut  interest  rates  to  boost  AD.  Also,  the  
MPC  will  want  to  keep  interest  rates  lower  to  try  to  reduce  
unemployment.  
• Exchange  rate.  A  depreciation  in  the  exchange  rate  could  cause  
inflationary  pressures  due  to  higher  import  prices  and  rising  AD.    
• Consumer  confidence/  spending.  Consumer  spending  is  one  of  biggest  
determinants  of  AD.  If  confidence  is  high  and  consumers  are  spending  
more,  it  may  lead  to  inflationary  pressures,  and  the  Bank  will  be  more  
likely  to  keep  interest  rates  high.  
• Borrowing  levels.  A  rise  in  borrowing  could  indicate  the  economy  is  
getting  close  to  full  capacity  and  is  in  danger  of  over-­‐heating.  Higher  
borrowing  may  require  higher  interest  rates  to  reduce  excess  demand.  

71  
 
Effect  of  higher  interest  rates  (tight  monetary  policy)  

 
If  inflation  is  forecast  to  rise  above  the  inflation  target,  the  MPC  is  likely  to  
increase  interest  rates.  This  will  help  reduce  AD  and  inflation  because  higher  
interest  rates:  
1. Make  borrowing  more  expensive,  therefore  people  spend  less  on  credit.  
Firms  will  also  be  less  willing  to  invest  by  borrowing  money.  
2. The  cost  of  mortgages  increases,  therefore  people  have  less  disposable  
income,  causing  a  fall  in  consumption.  Therefore,  AD  decreases.  
3. Saving  money  in  a  bank  is  more  attractive,  therefore  there  is  less  
spending  and  relatively  more  saving.  
4. Exchange  rate  increases.  With  higher  interest  rates,  it  is  more  attractive  
to  save  in  UK  banks.  This  increases  the  demand  for  the  British  Pound  and  
increases  the  exchange  rate.    A  higher  exchange  rate  will  reduce  the  
demand  for  (X-­‐M)  because  exports  are  more  expensive,  and  imports  
cheaper.  

 
 

72  
 
Evaluation  of  monetary  policy  
1.  The  effect  of  interest  rates  depends  on  the  situation  of  the  economy.  If  the  
economy  is  close  to  full  employment,  a  cut  in  interest  rates  is  likely  to  cause  a  
significant  increase  in  inflation,  but  only  a  small  increase  in  real  GDP  (AD3  to  
AD4).  

 
 

• However,  if  the  economy  has  spare  capacity  (e.g.  at  Y1  to  Y2),  higher  AD  
will  increase  GDP  with  only  a  small  amount  of  inflation.  

2.  Other  components  in  the  economy.  The  effectiveness  of  monetary  policy  
depends  upon  other  variables  in  the  economy,  for  example:  

• If  confidence  is  low,  a  reduction  in  interest  rates  may  not  increase  
demand.  
• If  taxes  are  rising,  this  may  counter  a  fall  in  interest  rates.  
• If  the  world  economy  is  slowing,  this  will  reduce  exports  and  AD;  this  
would  keep  spending  low,  even  if  there  was  a  reduction  in  interest  rates.  
 
3.  Time  lags.  There  may  be  time  lags  for  lower  interest  rates  to  have  an  effect.  
For  example,  higher  interest  rates  may  not  reduce  investment  in  the  short  term,  
because  firms  will  continue  with  existing  investment  projects.  
4.  Conflicts  of  objectives.  Monetary  policy  may  conflict  with  other  
macroeconomic  objectives.    If  the  MPC  reduces  inflation,  this  may  lead  to  lower  
growth  or  higher  unemployment.    

73  
 
5.  Worse  trade-­‐off.  In  2008,  the  UK  experienced  cost-­‐push  inflation  due  to  
rising  oil  prices,  the  MPC  didn’t  increase  interest  rates  because  the  economic  
growth  was  negative.  In  2008,  they  had  to  tolerate  inflation  being  above  target.  

6.  Exchange  rate  effect.  Cutting  interest  rates  will  cause  depreciation  in  
exchange  rate,  which  will  cause  imported  inflation.  

Quantitative  easing  
1. Quantitative  easing  involves  the  Central  Bank  creating  more  money  and  
trying  to  reduce  bond  yields.  
2. The  aim  of  quantitative  easing  is  to:  
1. Increase  the  supply  of  money  
2. Increase  the  inflation  rate  and  avoid  deflation  
3. Increase  bank  lending  and  increase  economic  growth  

How  quantitative  easing  works  

• The  Central  Bank  creates  money  electronically  (this  is  a  similar  effect  to  
printing  money).  
• The  Central  Bank  uses  these  extra  bank  reserves  to  buy  various  securities,  
such  as  government  bonds  and  corporate  bonds.  
• Commercial  banks  sell  assets  (bonds)  to  the  Central  Bank  for  cash.    
• Therefore,  banks  see  an  increase  in  their  liquidity  (cash  reserves).  
• In  theory,  with  more  cash  reserves,  the  bank  will  be  more  willing  to  lend  
to  customers.  This  lending  will  be  important  for  increasing  investment  
and  consumer  spending.  
• Buying  assets  reduces  their  interest  rate.  Lower  interest  rates  on  these  
securities  may  also  encourage  banks  to  lend.  Higher  lending  should  help  
improve  economic  growth.  

Evaluation  of  quantitative  easing  QE  in  the  UK  

• The  UK  Central  Bank  engaged  in  quantitative  easing  QE—  £375bn  of  new  
money  asset  purchases.  
• It  is  hard  to  quantify  the  effect  of  QE.  At  the  same  time,  the  UK  growth  was  
affected  by  deflationary  fiscal  policy  and  low  growth  in  Europe.  Perhaps,  
without  QE,  the  recession  would  have  been  deeper.  
• Government  bond  yields  did  fall,  making  it  cheaper  for  the  government  to  
borrow,  though  some  feared  a  bond  bubble.  
• Future  inflation?  Some  fear  that  quantitative  easing  creates  the  
possibility  of  future  inflation  because,  when  the  economy  recovers,  there  
is  excess  money  supply  in  the  financial  system,  which  may  be  hard  to  
remove.  However,  inflation  stayed  low  (2009-­‐2015).  
• Economic  growth  was  low/negative  between  2009  and  2012,  suggesting  
QE  was  of  limited  effect  in  boosting  economic  growth.  
 
 
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Liquidity  trap  
• A  liquidity  trap  occurs  when  expansionary  monetary  policy  fails  to  boost  
spending.  It  may  occur  when  an  increase  in  the  money  supply  fails  to  
translate  into  lower  interest  rates.  
• A  liquidity  trap  can  also  said  to  occur  when  the  central  bank  cuts  interest  
rates,  but  these  lower  interest  rates  fail  to  stimulate  demand  because  
consumers  prefer  to  save  and  hoard  cash.    
Consequence  of  a  liquidity  trap  

• Central  bank  might  try  unconventional  monetary  policy,  such  as  

quantitative  easing.  
• Rise  in  saving  levels,  but  fall  in  consumer  spending  and  investment.  
• Demand  likely  to  be  depressed,  leading  to  economic  downturn.  
 

Inflation  targeting  
Inflation  targeting  involves  a  Central  Bank  setting  a  specific  target  for  inflation.  

• Symmetric  inflation  target  is  when  Banks  have  to  prevent  inflation  
going  too  high,  but  also  prevent  it  going  too  low,  e.g.  Bank  of  England’s  
target  is  2%  +/-­‐1  (i.e.  keep  inflation  between  1%  and  3%).  
• Asymmetric  inflation  target  is  when  the  Central  Bank  only  have  to  
prevent  inflation  going  too  high,  e.g.  ECB  target  is  less  than  2%.  
The  idea  of  inflation  targeting  is  that:  

• It  removes  political  pressures  to  cut  interest  rates  before  an  election.  
• Targeting  low  inflation  may  reduce  inflation  expectations  and  make  it  
easier  to  keep  inflation  low.    
• If  people  have  confidence  in  Central  Bank  to  keep  inflation  low,  workers  
will  not  demand  large  wage  increases  to  compensate  for  inflation.  
Problems  with  inflation  targeting  

• If  there  is  cost  push  inflation  (e.g.  due  to  rising  oil  prices)  it  may  be  
difficult  for  Central  Bank  to  keep  inflation  on  target,  without  causing  a  
recession.  
• Inflation  is  not  the  only  macro-­‐economic  objective.  Economic  growth  and  
unemployment  are  just  as  important.  
• It  can  make  the  central  bank  inflexible,  e.g.  in  2011  when  the  ECB  tried  to  
reduce  inflation,  but  Eurozone  was  in  recession.  

75  
 
 Supply  side  policies    
Supply-­‐side  policies  are  government  attempts  to  increase  productivity,  make  the  
economy  more  efficient,  and  shift  aggregate  supply  to  the  right.  Supply-­‐side  
policies  can  be  either:  
1. Interventionist  —  involving  government  spending  to  overcome  market  
failure,  e.g.  building  new  roads  to  reduce  congestion.  
2. Market-­‐oriented  —  policies  to  reduce  regulation  and  allow  free  markets  
to  function  more  efficiently,  e.g.  reduce  minimum  wages.  
Supply-­‐side  improvements.  This  refers  to  general  improvements  in  the  
productivity  of  the  economy.  Supply-­‐side  improvements  could  be  due  to  private  
innovation,  improved  technology  or  government  supply-­‐side  policies.  

Benefits  of  supply  side  policies  

Successful  supply-­‐side  policies  can  help  the  economy  in  various  ways:  

 
 
1. Lower  inflation.  Shifting  AS  to  the  right  will  cause  a  lower  price  level.  
2. Lower  unemployment.  Supply-­‐side  policies  can  help  reduce  structural,  
frictional,  and  real-­‐wage  unemployment.  
3. Improved  economic  growth.  Supply-­‐side  policies  will  increase  
economic  growth  by  increasing  LRAS.  
4. Improved  trade  and  balance  of  payments.  By  making  firms  more  
competitive,  they  will  be  able  to  export  more,  improving  current  account  
on  balance  of  payments.    

76  
 
Market-­‐oriented  supply-­‐side  policies  
• Privatisation.    This  involves  selling  state-­‐owned  assets  to  the  private  
sector.  It  is  argued  that  the  private  sector  is  more  efficient  in  running  
businesses  because  they  have  a  profit  motive  to  reduce  costs  and  develop  
better  services.  
• Deregulation.  This  involves  reducing  barriers  to  entry  in  order  to  make  
the  market  more  competitive.  Greater  competition  creates  incentives  to  
reduce  prices  and  costs.  For  example,  UK  telecoms  market  is  now  more  
competitive,  and  this  has  helped  reduce  prices  and  increase  efficiency.  
• Reducing  taxes.  It  is  argued  that  lower  taxes  (income  and  corporation)  
increase  incentives  for  people  to  work  harder,  leading  to  higher  output.  
• Reducing  state  welfare  benefits.  Lower  unemployment  benefits  may  
create  a  bigger  incentive  for  people  to  look  for  work  and  stay  off  benefits.  
o However,  it  could  cause  an  increase  in  relative  poverty.  
• Labour  market  reforms.  Some  economists  argue  that  many  European  
labour  markets  are  too  heavily  regulated.  For  example,  removing  laws  
about  hiring  and  firing  workers  and  fixed  hour  contracts  would  increase  
labour  market  flexibility  and  encourage  firms  to  hire  workers.    
o On  the  downside,  greater  labour  market  flexibility  may  lead  to  
greater  job  insecurity  for  workers.  
• Immigration.  Allowing  more  immigration  could  help  the  economy  
become  more  flexible  and  deal  with  labour  shortages,  such  as  nurses  and  
teachers.    
o However,  an  increased  population  can  increase  pressure  on  
housing  and  infrastructure.  
• Raising  retirement  age  to  67  over  time.  Reduces  dependency  ratio  and  
increases  working  age  population.  It  means  longer  working  life  for  new  
generation  of  workers.  
• Raising  income  tax  threshold.  Hoping  to  encourage  more  people  into  
work  and  reducing  ‘benefit  trap’  thus  increasing  the  gap  between  work  
and  state  benefits.  

Interventionist  supply-­‐side  policies  

 

• Increased  education  and  training.  Better  education  can  improve  labour  

productivity  and  increase  AS.  Often  there  is  an  under-­‐provision  of  
education  in  a  free  market,  leading  to  market  failure.  Therefore,  the  
government  may  need  to  subsidise  suitable  training  schemes.  
• Providing  better  information  about  available  jobs.  
• Improving  transport  and  infrastructure.  In  a  free  market,  there  is  
likely  to  be  an  under-­‐provision  of  public  transport.  If  the  government  
spent  money  to  improve  transport  network,  firms  would  benefit  from  
lower  costs,  e.g.  the  HS2  train  link.  
• Improving  geographical  mobilities.  Shortage  of  housing  in  popular  
areas  can  cause  geographical  immobility.  The  government  could  try  to  
build  new  houses  or  impose  rent  controls.  

77  
 
 • Raising  minimum  wage  significantly  to  become  a  ‘living  wage’.  A  
significantly  higher  minimum  wage  could  encourage  more  people  to  enter  
the  labour  market  and  take  a  job.    
o However,  on  the  other  hand  higher  minimum  wage  could  lead  to  
unemployment  because  firms  can’t  afford  the  workers.  
 
 

Evaluation  of  supply-­‐side  policies  

• They  will  take  time  to  have  effect,  e.g.  it  will  take  several  years  to  create  a  
more  educated  workforce.  
• It  will  cost  money  to  improve  information  and  education,  and  therefore  
taxes  will  need  to  rise.  
• Deregulation,  such  as  lower  benefits  and  reduced  minimum  wages  may  
cause  side-­‐effects,  such  as  increased  poverty.  
• Government  failure  may  occur.  For  example,  the  government  may  have  
poor  information  about  what  to  spend  money  on.  For  example,  the  
government  may  finance  the  wrong  kind  of  scheme,  such  as  a  new  train  
line  that  is  not  used  very  much.  
• In  a  recession,  increasing  AS  may  be  insufficient.  In  a  recession,  policies  to  
increase  aggregate  demand  are  more  important  than  supply-­‐side  policies.  

 
• In  this  example  we  successfully  increase  LRAS,  but  the  economy  is  stuck  
in  a  recession,  so  the  increase  in  output  is  relatively  small.  In  this  
situation,  the  economy  needs  an  increase  in  AD  (demand-­‐side  policies).  

78  
 
 • There  is  only  so  much  the  government  can  do.  It  is  important  to  bear  in  
mind  that  technological  improvements  and  productivity  gains  come  
largely  from  the  private  sector.    
• It  is  difficult  for  the  government  to  transform  productivity  and  create  new  
technology.  At  best,  the  government  can  create  a  climate  for  private  
sector  innovation  to  occur.  
 

Policy  conflicts  
1. Higher  economic  growth  may  cause  environmental  problems,  e.g.  the  
overuse  of  scarce  (limited)  resources  acts  as  a  constraint  on  future  living  
standards.  
o However,  with  higher  economic  growth,  the  government  may  have  
more  tax  revenue  to  spend  on  looking  after  environment.  
Economic  development  may  also  lead  to  lower  industrialisation  
and  a  more  service  sector  based  economy.  
2. Higher  growth,  but  higher  inequality.  Lower  income  tax  and  
corporation  tax  may  provide  a  boost  to  growth,  but  may  also  increase  
inequality  because  high  earners  benefit  most  from  these  tax  cuts.  
o However,  it  depends  on  the  nature  of  growth.  Growth  could  enable  
lower  unemployment  and  more  opportunities  to  reduce  relative  
poverty.  
3. Reducing  government  debt,  but  increasing  inequality.  Cutting  down  
welfare  benefits  may  provide  an  incentive  for  the  unemployed  to  get  a  job,  
but  it  may  cause  increased  inequality.  
4. Growth  and  balance  of  payments.  Policies  to  reduce  a  current  account  
deficit  (e.g.  deflationary  fiscal  policy)  may  cause  lower  economic  growth  
and  higher  unemployment.    
5. Inflation  and  balance  of  payments.  If  a  government  tried  to  reduce  
current  account  deficit  through  devaluation,  it  could  cause  inflation,  due  
to  higher  import  prices  and  rising  AD.  
6. Growth  and  inflation.  Higher  economic  growth  could  cause  inflation,  if  it  
is  caused  by  higher  aggregate  demand.  
o However,  if  growth  is  sustainable  and  AS  and  AD  increase  at  a  
similar  rate,  growth  does  not  need  to  be  inflationary.  (See:  Phillips  
curve  for  more  detail)  
 
 

79  
 
 Approaches  to  macroeconomics  
Classical  approach  
Until  the  1930s,  the  dominant  view  of  economics  was  the  classical  view.  The  
classical  view  stressed  the  importance  of  free  markets.  

• The  classical  view  states  wages  and  prices  are  flexible  and  in  the  absence  
of  government  /  trade  union  interference  the  economy  should  maintain  a  
stable  equilibrium  and  full  employment.  
• Classical  economists  believe  LRAS  is  inelastic.  

Keynesian  approach  
The  great  depression  of  the  1930s  suggested  there  were  flaws  with  the  classical  
approach.  

• It  appeared  wages  and  prices  were  ‘sticky’  downwards.  Wages  did  not  fall  
to  meet  equilibrium,  and  mass  unemployment  persisted.  
• Keynes  also  argued  that  in  the  1930s  there  was  a  deficiency  of  aggregate  
demand  (AD).    
• Keynes  noted  that  a  free  market  did  not  solve  this  problem  on  its  own,  
and  therefore  he  advocated  government  intervention  (fiscal  policy)  and  
government  borrowing  to  stimulate  economic  activity.  
• Keynesians  believe  LRAS  can  be  elastic.  

Post  war  consensus  

In  1950s  and  1960s,  Keynesian  demand  management  was  quite  popular  and  
most  Western  economies  achieved  strong  economy  growth  and  full  employment.  

1970s  breakdown  of  Keynesian  consensus  

• In  the  1970s,  we  saw  a  break  down  in  the  stable  trade-­‐off  between  
unemployment  and  inflation.    
• Many  economies  saw  ‘stagflation’  –  higher  inflation  and  higher  
unemployment.  This  was  caused  by  rising  oil  prices  and  rising  wages,  
leading  to  cost-­‐push  inflation.  

Monetarist  approach  
• The  monetarist  approach  concentrates  on  reducing  inflation.  They  
believed  to  reduce  inflation  it  is  essential  to  control  the  money  supply.    
• Like  former  classical  economists,  they  were  sceptical  of  Keynesian  
demand  management.    They  believed  there  would  only  be  a  short-­‐run  
trade-­‐off  between  unemployment  and  inflation.  

80  
 
 • The  UK  adopted  monetarist  policies  in  early  1980s.  It  reduced  inflation  
but  caused  a  deep  recession  and  high  unemployment.  The  link  between  
the  money  supply  and  inflation  was  weaker  than  expected.  
• Monetarists  also  advocate  free  market  supply  side  policies  to  reduce  
structural  unemployment  and  increase  efficiency.  

2007-­‐09  financial  crisis    

• The  financial  crisis  of  2007-­‐09  brought  to  an  end  the  long-­‐period  of  
economic  stability  and  expansion.    
• The  crisis  exposed  how  problems  in  the  financial  system  could  have  
serious  adverse  effects  for  the  wider  economy.    
• It  led  to  calls  for  greater  regulation  of  the  banking  system  to  reduce  risk  
and  reduce  the  need  for  a  government  bailout.  
• The  financial  crisis  also  led  to  a  prolonged  recession.  
• The  crisis  led  to  a  liquidity  trap.  Cutting  interest  rates  to  zero  was  
insufficient  to  return  the  economy  to  normal  economic  growth.  
• There  was  a  return  of  Keynesian  economics  because  of  the  failure  of  
monetary  policy  to  boost  AD.  Many  felt  fiscal  policy  could  play  an  
important  role  in  overcoming  the  recession.  
• However,  many  governments  were  reluctant  to  pursue  fiscal  policy  
because  of  fears  over  the  level  of  government  borrowing.  

Euro  crisis  
• The  recession  of  2008  precipitated  a  crisis  in  the  Eurozone.  
• The  recession  caused  a  sharp  rise  in  government  borrowing.  
• Many  European  countries,  such  as  Ireland  and  Spain,  saw  a  collapse  in  the  
housing  market,  which  caused  further  problems  for  banks.  
• Countries  in  the  Eurozone  could  not  devalue  their  exchange  rate  to  
restore  competitiveness.  There  was  a  trade  imbalance  between  different  
Eurozone  countries,  which  worsened  the  recession.  
• Many  countries  pursued  austerity  (spending  cuts  to  reduce  government  
borrowing),  but  this  austerity  often  exacerbated  the  economic  downturn.  

Austrian  economics  
Another  economic  view  is  that  of  “Austrian  economics”.  They  believe:  

• Laissez  faire  ‘free  market’  economics  is  the  most  efficient.  Government  
intervention  is  inevitably  inefficient.  Therefore,  they  stress  the  
importance  of  reducing  government  interference  and  leaving  the  
workings  of  the  economy  to  the  free  market.  
• They  believe  recessions  are  caused  by  credit  cycles,  and  usually  blame  the  
central  banks  for  keeping  interest  rates  too  low  for  too  long.  
• They  support  the  gold  standard  as  a  way  to  prevent  inflation.  

81  
 
 Globalisation  
Globalisation  refers  to  the  process  of  how  national  economies  are  becoming  
increasingly  interdependent  and  integrated.    

• In  practice,  globalisation  refers  to  the  increased  flow  of  labour,  capital  and  
trade  between  different  countries,  and  a  breakdown  of  barriers  between  
countries.  

Characteristics  of  globalisation  

• Growth  in  free  trade  between  countries  
• Growth  in  movement  of  labour  and  capital  across  national  borders  
• Increased  importance  of  global  financial  systems  
• Growth  in  trading  blocs  (groups  of  countries,  like  EU)  
• Growth  of  multinational  companies  who  operate  around  the  world  

Causes  of  globalisation  

• Growth  of  free  trade.  Trade  is  increasingly  important  to  the  global  
economy.  Economies  increasingly  rely  on  importing  raw  materials  and  
exporting  goods  to  foreign  markets.  Increased  trade  has  made  countries  
more  closely  integrated.  
• Multinational  companies.  There  has  been  a  growth  in  the  number  of  
multinational  companies  who  have  an  influential  cross-­‐border  presence.  
Multinationals  have  different  production  processes  across  the  globe.  
• Technology.  The  development  of  technology,  such  as  the  internet,  has  
helped  improve  communication  and  made  it  easier  to  connect  to  all  
corners  of  the  world.  
• Transport.  Improved  transport,  especially  air  transport  and  shipping,  has  
helped  to  make  trade  cheaper,  and  also  made  it  easier  for  labour  to  move  
between  different  countries.  
• WTO.  Institutions  like  the  WTO  have  helped  reduce  barriers  to  trade  and  
provide  a  forum  for  discussing  global  issues.    
• Trading  blocs.  Trading  areas  like  the  EU  have  considerably  reduced  
barriers  to  trade  within  Europe,  and  also  raised  the  profile  of  
international  co-­‐operation.  
• Opening  up  of  China  and  Eastern  Block.  Since  the1980s,  China,  India,  
Brazil  and  Russia  have  become  much  more  open  to  the  global  economy.  
China  has  been  a  key  player  in  the  development  of  the  global  economy,  e.g.  
its  investment  in  Africa  to  benefit  from  raw  materials.  
 
 

82  
 
Impact  of  globalisation    
• Global  trade  cycles.  Because  economies  are  more  closely  linked,  a  
recession  in  a  major  economy  like  the  US  or  Eurozone  is  likely  to  push  
many  economies  into  recession.      
o On  the  other  hand,  countries  can  benefit  from  growth  in  other  
countries  through  selling  more  exports.  
• International  co-­‐operation.  Globalisation  has  increased  the  importance  
of  reaching  global  agreements.    For  example,  it  is  no  good  reducing  
carbon  emissions  for  one  country;  it  needs  to  involve  all  countries.  
• Interdependence.  Countries  are  increasingly  interdependent.  China  has  
become  reliant  on  Africa  for  raw  materials.  Africa  is  reliant  on  China  for  
inward  investment.  

Impact  of  globalisation  on  workers  

• New  opportunities.  Some  workers  have  benefited  from  globalisation,  e.g.  
finding  new  opportunities  to  work  abroad,  like  workers  from  Eastern  
Europe  coming  to  work  in  Western  Europe.  
o However,  this  migration  has  created  friction  and  problems,  such  as  
housing  shortages.  Some  migrant  workers  have  been  exploited  due  
to  the  illegal  nature  of  migration.  
 
• Wages.  Globalisation  has  also  helped  equalise  wages  across  the  world.  
For  example,  self-­‐employed  computer  programmers  in  India  can  work  for  
US  firms  through  the  internet.  
o However,  only  a  small  percentage  of  workers  in  developing  
countries  can  benefit  from  globalisation  and  they  still  retain  low  
pay.  
 
• Foreign  direct  investment  has  created  manufacturing  jobs  in  developing  
countries,  e.g.  clothing  retailers  setting  up  in  Asia.  
o However,  there  has  been  criticism  of  ‘sweat  shops’,  with  workers  
in  developing  countries  getting  low  wages  and  dealing  with  poor  
working  conditions.    
o On  the  other  hand,  the  new  jobs  have  helped  give  workers  more  
choice  and  may  be  better  remunerated  than  working  in  agriculture.  
 
• Skilled  labour.  A  key  factor  is  whether  workers  have  the  sufficient  skills  
to  thrive  in  a  global  economy.  For  example,  those  who  are  well-­‐educated  
and  fluent  in  English  have  far  more  opportunities  than  unskilled  workers,  
who  are  less  likely  to  benefit  from  globalisation.    

 
 

83  
 
Impact  of  globalisation  on  firms  
• Uncompetitive  domestic  firms.  Some  local  firms  may  be  pushed  out  of  
business  by  large  multinationals  that  can  use  economies  of  scale  and  
monopsony  buying  power.  The  forces  of  globalisation  can  lead  to  
temporary,  structural  unemployment,  as  local  firms  become  
uncompetitive.    
o However,  equally,  globalisation  creates  opportunities  for  new  
firms  who  have  the  flexibility  to  meet  the  new  demand  for  
products  and  services  from  globalisation.  
 
• Lower  costs  for  multinationals.  Multinational  companies  have  been  
able  to  reduce  costs  by  outsourcing  labour-­‐intensive  work  to  countries  
with  low  labour  costs.  This  helps  products  to  be  cheaper.  
o However,  there  are  also  costs  to  outsourcing  (e.g.  bad  potential  
publicity  from  ‘sweat  shop’  factories),  and  it  is  possibly  harder  to  
maintain  quality  of  production.  
 
• Economies  of  scale.  Global  scale  production  has  enabled  greater  
economies  of  scale  and  lower  costs.  This  is  significant  for  industries  with  
high  fixed  costs,  like  cars  and  aeroplanes.  
o However,  some  domestic  firms  are  not  able  to  gain  sufficient  
economies  of  scale  and  so  have  lost  out.  
 
• Impact  on  firms  in  the  developing  world.  Arguably,  some  developing  
countries  have  benefited  less  from  globalisation,  e.g.  their  comparative  
advantage  has  been  in  producing  raw  materials,  but  relying  on  primary  
products  leads  to  an  unbalanced  economy  dependent  on  raw  material  
prices.  
o But  globalisation  has  also  given  new  opportunities  to  firms  in  
developing  countries,  e.g.  computer  software  firms  in  India  can  
effectively  compete  because  of  the  internet.  

Impact  of  globalisation  on  the  environment  

• Environmental  costs.  Globalisation  has  meant  goods  are  increasingly  
imported  from  across  the  planet,  rather  than  using  local  produce.  This  
increases  the  carbon  and  pollution  impact  of  food  and  trade.    
o Also,  globalisation  enables  firms  to  switch  production  to  countries  
with  weaker  environmental  legislation.  
 
However,  

• Globalisation  has  slowly  raised  the  importance  of  global  co-­‐operation  to  
deal  with  environmental  challenges.  
• Some  aspects  of  globalisation  have  helped  to  improve  the  environment,  
e.g.  the  media  can  make  us  more  aware  of  the  environmental  costs  
elsewhere  in  the  world,  and  the  internet  has  reduced  need  for  some  travel.  

84  
 
Multinational  companies  
Multinational  companies  have  operations  all  over  the  world,  e.g.  Shell,  Nike,  
Pepsi,  and  Toyota.  
Advantages  of  multi-­‐national  companies  

• Enable  economies  of  scale,  which  is  important  for  industries  with  high  
fixed  costs,  such  as  car  and  aeroplane  manufacturers.  
• Greater  size  and  profit  gives  more  scope  for  investment  in  research  and  
development.  
• Create  wealth  and  jobs  around  the  world.  Inward  investment  by  
multinationals  offer  much  needed  foreign  currency  for  developing  
economies.        
• Global  companies  can  ensure  minimum  standards.  The  success  of  
multinationals  is  often  because  consumers  like  to  buy  goods  and  services  
where  they  can  rely  on  minimum  standards,  e.g.  Coca-­‐Cola,  Starbucks.  

Disadvantages  of  multi-­‐national  companies  

• They  may  take  a  high  percentage  of  revenue  from  mining  and  other  
operations  in  developing  countries.  
• Multinationals  can  develop  monopoly  power,  which  enables  them  to  set  
higher  prices  for  consumers.  Multinationals  can  also  develop  monopsony  
power  and  exploit  suppliers  and  workers.  
• In  developing  economies,  the  success  of  multinationals  may  push  smaller  
local  firms  out  of  business.  
• The  environmental  record  of  multinationals  has  been  mixed.  

Impact  of  emerging  economies  on  UK  economy  

Emerging  economies  are  those  economies,  which  are  growing  fast  and  have  
made  considerable  development.  For  example,  China,  Brazil,  India.  (BRIC)  

• Export  demand.  High  economic  growth  in  emerging  economies  leads  to  
increased  demand  for  UK  exports  and  services.  For  example,  high  demand  
for  UK  education  from  China  and  India.    
o Currently,  emerging  economies  are  a  small  %  of  UK  exports,  but  it  
is  growing  and  offers  more  potential  in  the  future.  
• Cheap  manufactured  goods.  China  and  India  have  helped  keep  costs  of  
exports  low.  This  can  help  reduce  the  price  of  manufactured  goods.  
o However,  there  is  also  increased  demand  for  raw  materials.  Strong  
growth  from  emerging  economies  has  put  upward  pressure  on  the  
demand  and  price  of  raw  materials.  This  can  cause  cost-­‐push  
inflation  (e.g.  2008-­‐09).  
• Structural  change.  The  growth  of  cheap  manufacturing  has  led  to  a  
decline  in  UK  manufacturing,  speeding  up  the  change  to  a  service  sector  
based  economy,  e.g.  finance.  
o However,  economies  are  always  changing  and  comparative  
advantage  will  continue  to  evolve.  

85  
 
 Trade  
• International  trade  allows  countries  to  specialise  in  goods  and  services  
which  they  are  relatively  best  at  producing.    
• Absolute  advantage.  This  occurs  when  one  country  can  produce  a  good  
with  fewer  resources  than  another.    
• Comparative  advantage.  A  country  has  a  comparative  advantage  if  it  can  
produce  a  good  at  a  lower  opportunity  cost,  e.g.  it  has  to  forego  less  of  
other  goods  in  order  to  produce  it.    
• The  law  of  comparative  advantage.  This  states  that  trade  can  benefit  all  
countries  if  they  specialise  in  the  goods  in  which  they  have  a  comparative  
advantage.  

Example  of  trade  

Let  us  assume  there  are  two  countries,  India  and  the  UK,  who  could  both  produce  
items  of  clothing  or  computers.  
Opportunity  cost  of  producing  clothes  or  computers  
    Clothes   Computers  
 
    UK   1   4  
  India   2   3  
  Total   3   7  
 

• For  the  UK  to  produce  1  unit  of  clothes,  it  has  an  opportunity  cost  of  4  
computers.  
• For  India  to  produce  1  unit  of  clothes,  it  has  an  opportunity  cost  of  1.5  
computers.  
• Therefore,  India  has  a  comparative  advantage  in  producing  textiles,  
because  it  has  a  lower  opportunity  cost.  

Opportunity  cost  of  producing  books  

• If  the  UK  produces  a  computer,  the  opportunity  cost  is  1/4  (0.25).  
• If  India  produces  a  computer,  the  opportunity  cost  is  2/3  (0.66).  
• Therefore,  the  UK  has  a  comparative  advantage  in  producing  computers.  
Output  after  specialisation  
Clothes   Computers  
 
UK   0   8  
India   4   0  
TOTAL   4   8  

86  
 
 • If  each  country  now  specialises  in  producing  one  good  then,  assuming  
constant  returns  to  scale,  output  will  double.  
• Therefore,  output  of  both  goods  has  increased,  illustrating  the  gains  from  
comparative  advantage.  
• The  total  output  is  now  4  (clothes)  and  8  (computers),  which  is  higher  
than  the  previous  totals.  

Limitations  of  the  theory  of  comparative  advantage  

• Assumes  no  transport  costs  but,  in  reality,  transport  costs  can  prohibit  
the  benefits  of  trade.  
• Increased  specialisation  may  lead  to  diseconomies  of  scale  (though  
also  economies  of  scale  can  occur).  
• Governments  may  restrict  trade  through  tariffs.  
• Comparative  advantage  measures  static  advantage,  but  not  any  
dynamic  advantage.    For  example,  in  the  future,  India  could  become  
good  at  producing  books  if  it  made  the  necessary  investment.  

Heckscher-­‐Ohlin  theory  of  trade  

• This  states  that  if  two  countries  trade  with  each  other,  they  will  export  
the  goods  in  which  they  have  the  more  abundant  factor  of  production.  
• A  capital  abundant  country  will  specialise  in  producing  and  exporting  
capital  intensive  goods,  and  import  those  labour  intensive  goods,  in  which  
it  does  not  have  an  advantage.    
• In  more  detail,  we  can  separate  labour  into  skilled  and  unskilled.    
• A  country  like  Germany  may  specialise  in  exporting  goods  which  require  
skilled  labour.  A  developing  economy  like  China  may  specialise  in  goods  
which  require  low  cost  unskilled  labour.  
• In  essence  the  Heckscher-­‐Ohlin  theory  is  based  on  principles  of  
comparative  advantage.  

Restrictions  on  free  trade  

Protectionism  involves  policies  to  restrict  trade.  This  can  involve:  

• Higher  tariffs  (type  of  tax  on  imports)  

• Non-­‐tariff  barriers,  e.g.  the  US  have  charges  on  packages  under  grounds  
of  ‘aviation  security’,  and  this  increases  the  costs  of  imports.    Other  rules  
and  regulations  can  make  trade  more  difficult.  
• Voluntary  export  restraint  is  effectively  a  type  of  quota  where  
voluntary  limits  are  placed  on  imports  of  goods.  
• Embargo,  e.g.  US  embargo  with  Cuba.  
• Government  subsidy.  Government  subsidies  effectively  give  the  firm  an  
unfair  competitive  advantage.  This  has  often  occurred  with  national  
airlines.  
• Distorted  exchange  rate.  Keeping  your  currency  artificially  low  makes  
exports  relatively  more  competitive.  

87  
 
Benefits  of  free  trade  
1. Reducing  tariff  barriers  leads  to  trade  creation.  Trade  creation  occurs  
when  consumption  switches  from  high  cost  producers  to  low  cost  
producers,  enabling  an  increase  in  economic  welfare.  

 
 

• The  removal  of  tariffs  leads  to  lower  prices  for  consumers  (P1  –  P2)  and  
an  increase  in  consumer  surplus  (1+2+3+4).  
• The  government  will  lose  tax  revenue  of  area  3.  
• Domestic  firms  will  sell  less  and  lose  producer  surplus  of  area  1.  
• There  will  be  an  increase  in  overall  economic  welfare  of:  (2+4).  
2. Increased  exports.  If  UK  firms  have  a  comparative  advantage  then,  with  
lower  tariffs,  they  will  be  able  to  export  more,  and  create  more  jobs.  
3. Economies  of  scale.  If  countries  can  specialise  in  certain  goods,  they  can  
benefit  from  economies  of  scale  and  lower  average  costs.  This  is  especially  
true  in  industries  with  high  fixed  costs,  or  those  that  require  high  levels  of  
investment.  
4. Increased  competition.  With  more  trade,  domestic  firms  will  face  more  
competition  from  abroad  and,  therefore,  there  will  be  more  incentives  to  cut  
costs  and  increase  efficiency.  It  may  prevent  domestic  monopolies  from  
charging  too  high  prices.  
5. Trade  is  an  engine  of  growth.  World  trade  has  increased  by  an  average  of  
7%  a  year  since  1945;  it  is  a  big  contributor  to  global  economic  growth.  
6. Make  use  of  surplus  raw  materials.  Countries  with  large  reserves  of  raw  
materials  need  trade  to  benefit  from  their  natural  wealth.  
 

88  
 
Arguments  for  restricting  trade  
• Infant  industry  argument.  If  developing  countries  have  industries  
that  are  relatively  new  then,  at  that  moment,  these  industries  would  
struggle  against  international  competition.  Therefore,  they  need  tariff  
protection  while  they  develop  their  industries  to  be  more  competitive.    
 

• The  senile  industry  argument.  If  industries  are  declining  and  

inefficient,  they  may  require  a  large  investment  to  make  them  efficient  
again.  Protection  for  these  industries  could  act  as  an  incentive  for  
firms  to  invest  and  reinvent  themselves.  
 

• Need  to  diversify  the  economy.  Many  developing  countries  rely  on  
producing  primary  products,  in  which  they  currently  have  a  
comparative  advantage.  However,  relying  on  agricultural  products  has  
several  disadvantages:  
o Prices  can  fluctuate  due  to  environmental  factors.  
o Goods  have  a  low  income  elasticity  of  demand.  Therefore,  even  
with  economic  growth,  demand  will  only  increase  a  little.  
 

• Protection  against  dumping.  The  EU  sold  a  lot  of  its  food  surplus  
from  the  CAP  at  very  low  prices  on  the  world  market.  This  caused  
problems  for  world  farmers  because  they  saw  a  big  fall  in  their  market  
prices.  Tariffs  can  protect  against  dumping.  
• Environmental.  It  is  argued  that  free  trade  can  harm  the  environment  
because  countries  with  strict  pollution  controls  may  find  that  
consumers  import  the  goods  from  other  countries  where  legislation  is  
lax  and  pollution  is  allowed.    
 
 

International  competitiveness  
The  UK’s  international  competitiveness  measures  the  relative  cost  of  British  
exports.    
If  UK  goods  and  services  become  more  expensive  than  our  competitors,  then  we  
see  a  decline  in  competitiveness.    

International  competitiveness  can  be  measured  using  

• Unit  labour  costs  –  costs  of  employing  workers  to  produce  goods  
• Relative  prices  of  exports  and  imports.  
 

89  
 
Factors  influencing  international  competitiveness    
1. Labour  productivity  (output  per  worker).  If  German  productivity  rises  
faster  than  the  UK,  we  would  expect  Germany  to  become  more  
competitive.  Labour  productivity  will  depend  on  factors  such  as:  
• Levels  of  education  and  training.  
• Mobility  of  labour.  High  mobility  will  increase  overall  productivity.  
• Motivation  of  workers.  If  workers  enjoy  work  and  feel  part  of  the  
process,  productivity  will  be  higher.  
• Successful  implementation  of  technology  will  help  productivity.  
 
2. Relative  inflation  rates.  If  the  UK  experiences  lower  inflation  than  our  
main  competitors,  this  will  reduce  our  relative  costs  and  make  us  more  
competitive.  
3. Unit  labour  costs.  The  full  cost  of  employing  workers,  including  wages,  
taxes  and  regulations.  
4. Levels  of  infrastructure  (e.g.  transport,  communication).  If  a  country  
experiences  transport  bottlenecks,  it  will  lead  to  higher  costs  of  business  
and  lower  competitiveness.  
5. Cost  of  business.  Levels  of  regulation  and  taxes.  High  taxes  and  regulated  
labour  markets  can  reduce  competitiveness.  
6. Exchange  rate.  An  undervalued  exchange  rate  will  make  exports  more  
competitive.    

Measures  to  increase  competitiveness  

• Education  and  training.  This  increases  labour  productivity  and  makes  
labour  markets  more  flexible.    Education  can  take  several  years  to  have  an  
effect  but  is  important  for  increasing  long-­‐term  productivity.  
• Investment  in  infrastructure  e.g.  better  transport  links.    This  helps  
reduce  costs  for  firms  and  improves  productivity  in  the  economy.  
However,  it  is  expensive,  takes  time  and  there  is  a  danger  of  government  
failure,  e.g.  spending  on  the  wrong  kind  of  infrastructure.    
• Privatisation  and  deregulation.  This  aims  to  increase  efficiency  from  
the  incentives  of  competition  and  the  private  sector  profit  motive.  
• Devaluation  in  exchange  rate.  This  gives  a  temporary  boost  to  
competitiveness,  as  exports  are  cheaper.  However,  it  doesn’t  deal  with  
underlying  issues  of  competitiveness,  such  as  productivity  and  wage  costs.  
Devaluation  can  also  lead  to  inflation,  which  undermines  competitiveness  
in  the  long  run.  
• Limiting  wage  growth.  Lower  wage  costs  are  important  for  improving  
competitiveness  in  many  industries.  However,  it  can  be  difficult  for  the  
government  to  limit  wages.  Also,  it  may  be  better  to  try  to  increase  labour  
productivity,  rather  than  rely  on  low  wages  to  increase  competitiveness.  
 

90  
 
 The  balance  of  payments  
The  balance  of  payments  is  a  record  of  a  country’s  transactions  with  the  rest  of  
the  world.  It  shows  the  receipts  from  trade,  and  consists  of  the  current  and  
financial  account/capital  account.  

• Current  account  =  financial  +  capital  account  

Current  account  
The  current  account  is  primarily  concerned  with  the  balance  of  trade  in  goods  
and  services.  The  full  components  of  the  current  account  include:  

1. Trade  in  goods  (visible),  e.g.  cars,  computers,  food.  

2. Trade  in  services  (invisible),  e.g.  tourism,  insurance,  banking.  
3. Net  income  flows  (interest,  dividends  and  investment  income  from  
abroad).  
4. Net  current  transfers  (e.g.  government  aid,  payments  to  EU).  
 
• A  deficit  on  the  current  account  means  that  the  value  of  imports  is  greater  
than  the  value  of  exports.  
• A  deterioration  in  the  current  account  means  that  we  get  a  bigger  deficit  or  
we  go  from  a  surplus  to  a  deficit.    

In  the  past  ten  years,  the  UK  has  run  a  persistent  deficit  on  the  current  account.  

91  
 
Financial  account    
This  is  the  other  part  of  the  balance  of  payments.  It  is  a  record  of  all  transactions  
for  financial  investment.  It  includes  financial  flows  (e.g.  saving  in  banks)  and  net  
investment  (e.g.  foreign  firms  building  factories  in  the  UK).  
Capital  account    

This  involves  capital  transfers  or  the  acquisition  of  non-­‐financial  assets.  It  is  
relatively  small  compared  to  the  other  components.  

Factors  that  cause  a  current  account  deficit    

1.  Overvalued  exchange  rate.  If  the  currency  is  overvalued,  imports  will  be  
cheaper  and  therefore  there  will  be  a  higher  quantity  of  imports.  Exports  will  
become  uncompetitive  and  therefore  there  will  be  a  fall  in  the  quantity  of  
exports.  
2.  Economic  growth.  If  there  is  an  increase  in  real  wages,  people  will  have  more  
disposable  income  to  consume  goods.  If  domestic  producers  cannot  meet  the  
domestic  demand,  consumers  will  import  goods  from  abroad.    Consumer-­‐led  
growth  often  causes  a  deterioration  in  the  UK  current  account.  

3.  Inflation/  decline  in  competitiveness.  If  there  is  relatively  high  inflation  in  
the  UK  compared  to  our  competitors,  there  will  be  less  demand  for  UK  exports  
because  British  consumers  will  prefer  buying  cheaper  imports.    

• A  decline  in  competitiveness  could  be  caused  by  factors  such  as  poor  
infrastructure,  higher  wages,  and  lower  productivity.  

Policies  to  reduce  a  balance  of  payments  deficit  

1.  Devaluation  (expenditure-­‐switching  policy).  This  involves  reducing  the  value  
of  the  currency  against  others,  and  making  exports  cheaper  and  imports  more  
expensive.  This  should  increase  the  quantity  of  exports  and  reduce  imports.  

• We  would  expect  a  devaluation  to  lead  to  an  improvement  in  the  current  
account.  However,  it  does  depend  upon  the  elasticity  of  demand  for  
exports  and  imports.  Demand  needs  to  be  relatively  elastic  for  a  
devaluation  to  improve  the  current  account.  
• A  problem  with  devaluation  is  that  it  can  lead  to  imported  inflation.  This  
will  reduce  competitiveness  in  the  long  run,  and  will  mean  that  the  
improvement  in  the  current  account  might  only  be  temporary.  
• Also,  in  a  floating  exchange  rate,  the  UK  government  does  not  set  the  
exchange  rate;  therefore,  they  would  need  to  rely  on  a  market  
depreciation  in  the  exchange  rate.  

2.  Reduce  consumer  spending  (expenditure-­‐reducing  policy).  The  government  

could  pursue  tight  fiscal  policy  (higher  tax  to  reduce  consumer  spending)  or  the  
Bank  of  England  could  increase  interest  rates.  Lower  consumer  spending  will  
lead  to  less  spending  on  imports,  improving  the  current  account.  
92  
 
 • The  UK  has  a  high  marginal  propensity  to  import;  therefore,  a  reduction  
in  AD  improves  the  current  account  significantly.  
• Deflationary  policies  will  also  put  pressure  on  manufacturers  to  reduce  
costs  which  will  lead  to  more  competitive  exports,  and  so  exports  may  
increase.  
• However,  this  policy  will  conflict  with  other  macroeconomic  objectives.  
With  lower  AD,  economic  growth  is  likely  to  fall,  causing  higher  
unemployment.  The  government  is  likely  to  feel  that  growth  and  
employment  are  more  important  than  the  current  account  deficit.  

 
3.  Supply-­‐side  policies.  These  are  policies  aimed  at  increasing  productivity  and  
competitiveness.  If  successful,  they  will  make  UK  exports  more  competitive  and  
export  demand  will  rise.  For  example,  the  government  could  try  to  deregulate  
labour  markets  to  reduce  wage  costs  and  lower  costs  for  exporters.  

• Supply-­‐side  policies  will  take  a  considerable  time  to  have  an  effect  (e.g.  it  
takes  time  to  build  new  roads).  Also,  there  is  no  guarantee  that  more  
flexible  labour  markets  would  improve  competitiveness,  because  lower  
wages  may  reduce  worker  morale.  
• However,  supply-­‐side  policies  would  help  other  areas  of  the  economy  like  
economic  growth  and  unemployment.  
 

Effect  of  a  current  account  deficit  

If  the  UK  has  a  current  account  deficit,  it  can  have  the  following  effects:  

1.  Lower  AD.  A  deficit  (X-­‐M)  represents  a  leakage  from  the  economy.  Money  is  
being  spent  in  other  countries  and,  therefore,  ceteris  paribus,  it  reduces  UK  
aggregate  demand.    

• On  the  other  hand,  a  current  account  deficit  may  occur  due  to  high  levels  
of  consumer  spending  and  economic  growth.  The  deficit  is  often  smaller  
in  a  recession.  
• A  recession  in  the  Eurozone  would  reduce  the  demand  for  UK  exports.  
2.  Depreciation.  A  current  account  deficit  could  cause  a  depreciation  in  the  
value  of  the  exchange  rate,  because  we  are  buying  imports  and,  therefore,  buying  
foreign  currency.    

• A  depreciation  will  act  as  a  stabiliser  to  improve  the  current  account,  
because  it  makes  exports  more  competitive.  
• If  AD  increases  at  the  same  rate  as  AS,  we  can  get  economic  growth  
without  inflation.  
 
 

93  
 
Current  account  surplus  
A  current  account  surplus  occurs  when  the  value  of  imports  is  less  than  exports.  

• Some  countries,  such  as  China  and  Germany,  have  experienced  a  large  
current  account  surplus.    

Potential  problems  of  a  large  current  account  surplus:  

• It  represents  an  unbalanced  economy  —  dominated  by  exports  and  

showing  low  levels  of  consumer  spending.  
• If  one  country  runs  a  large  current  account  surplus,  it  means  other  
countries  will  have  a  similar  deficit.  For  example,  the  large  current  
account  surplus  of  Germany  was  matched  by  deficits  in  Southern  Europe  
(Greece,  Portugal,  Spain).  
• In  the  Eurozone,  current  account  imbalances  are  more  of  a  problem  
because  countries  can’t  rely  on  a  depreciation  to  solve  the  imbalance.  

A  government  could  reduce  a  current  account  surplus  by:  

• Allowing  the  exchange  rate  to  appreciate,  reducing  competitiveness.  
• Encouraging  consumer  spending  (e.g.  lower  income  tax),  leading  to  higher  
import  spending.  
 

94  
 
 Exchange  rates  
• The  exchange  rate  measures  the  value  of  a  currency  against  other  
currencies.  
• Bilateral  exchange  rate  measures  the  exchange  rate  for  two  countries,  
e.g.  the  value  of  the  Pound  Sterling  against  the  Dollar.  
• Nominal  exchange  rate  measures  the  actual  monetary  value,  and  the  
amount  of  currency  you  can  get  e.g.  £1=$1.5.  
• Real  exchange  rate  takes  into  account  inflation  and  measures  the  
amount  of  goods  you  can  exchange.    The  real  exchange  rate  =  nominal  
exchange  rate  X  (domestic  price  /  foreign  price).  
• Effective  exchange  rate.  The  weighted  average  of  a  currency  adjusted  
for  inflation,  like  real  exchange  rate.  
• Appreciation  is  the  increase  in  value  of  exchange  rate.  
• Depreciation/devaluation  is  the  decrease  in  value  of  exchange  rate.  
• Floating  exchange  rate  is  the  value  of  exchange  rate  determined  by  
market  forces.  
• Fixed  exchange  rate  is  the  government  committed  to  keeping  exchange  
rate  at  set  value.  
• Hybrid  or  semi-­‐fixed  exchange  rate  is  the  government  committed  to  
keeping  exchange  rate  within  a  certain  band  /  peg,  e.g.  £1  =  €1.1  to  €1.2.  
It  is  a  mixture  of  floating  exchange  rates  and  fixed  exchange  rates.  
Exchange  rate  index  for  the  Pound  Sterling  

95  
 
 • A  trade-­‐weighted  index  means  that  we  measure  the  value  of  the  British  
Pound  against  a  basket  of  currencies.  
• We  give  a  weighting  to  the  most  important  currencies  (e.g.  the  Euro  and  
the  US  Dollar  will  have  the  biggest  weighting  because  most  trade  is  with  
the  Eurozone  and  then  the  US).  
• This  exchange  rate  index  shows  a  20%  fall  in  the  value  of  the  Pound  
Sterling  between  2007  and  2009.  
 

Factors  that  influence  exchange  rates  

 

• Inflation.  If  inflation  in  the  UK  is  relatively  lower  than  elsewhere,  UK  
exports  will  become  more  competitive,  and  there  will  be  an  increase  in  
demand  for  Pound  Sterling  to  buy  UK  goods.  Countries  with  lower  
inflation  rates  tend  to  see  an  appreciation  in  the  value  of  their  currency.  
• Interest  Rates.  If  UK  interest  rates  rise  relative  to  elsewhere,  it  will  
become  more  attractive  to  deposit  money  in  the  UK.  Therefore,  the  
demand  for  Sterling  will  rise,  causing  “hot  money  flows”.  Higher  interest  
rates  cause  an  appreciation.  
• Speculation.  If  foreign  currency  dealers  become  pessimistic  about  the  
state  of  the  UK  economy,  they  may  sell  Sterling.  They  could  become  
pessimistic  about  prospects  for  growth,  high  government  debt,  and  future  
inflation.  Movements  in  exchange  rates  don’t  always  reflect  fundamentals,  
but  reflect  future  forecasts.  
• Balance  of  payments.  If  a  country  has  a  large  current  account  deficit,  it  
may  cause  depreciation  because  there  is  a  net  outflow  of  currency.  
 

Purchasing  power  parity  (PPP)  

• Real  GDP  at  purchasing  power  parity  (PPP)  takes  into  account  the  
relative  costs  of  living.    
• It  is  a  better  guide  to  actual  living  standards,  and  a  reflection  of  the  value  
of  goods  and  services  that  people  can  buy  in  the  economy.  
• When  comparing  real  GDP  per  capita  between  different  countries,  we  
need  to  take  into  account  that  the  fact  exchange  rates  may  not  reflect  the  
local  purchasing  power.  
• If  you  spend  $10  in  the  US,  you  may  be  able  to  buy  one  meal.  If  you  
convert  $10  into  Indian  Rupees,  you  will  get  about  600  Rupees.  But  with  
these  600  Rupees  you  can  perhaps  purchase  two  meals,  because  living  
costs  are  relatively  cheaper.    
• In  other  words,  $1  can  go  further  in  some  countries  than  others.    

96  
 
Big  Mac  Index  
 

• The  Big  Mac  index,  published  by  the  Economist  magazine,  offers  a  rough  
illustration  of  this  difference  in  relative  living  costs.    
• It  shows  the  US  dollar  cost  of  a  Big  Mac  in  different  countries.  In  theory,  
the  ingredients  are  the  same,  so  a  difference  in  price  reflects  different  
exchange  rates.  
• The  price  of  a  Big  Mac  can  vary  from  $1.50  in  South  Africa  to  $4.00  in  
Japan.  
• When  making  comparisons  of  living  standards,  we  need  to  bear  this  in  
mind.  People  may  have  higher  income  in  Japan,  but  the  cost  of  living  is  
also  relatively  higher.  

Evaluation  of  PPP  

• Different  countries  may  not  have  the  same  range  of  goods  to  make  
comparisons.  
• It  depends  whether  goods  are  produced  and  sold  domestically  or  
commodities  sold  in  global  markets.  Primary  products  more  likely  to  be  
close  to  PPP,  expensive  manufactured  goods  more  likely  to  be  close  to  
official  exchange  rate.  
 

Government  intervention  in  foreign  exchange  markets  

• Buying/  selling  currency.  Governments  could  use  foreign  currency  
reserves  to  buy  Pounds  and  increase  the  value  of  the  Pound.  Though  
foreign  currency  reserves  are  limited.  
• Changing  interest  rates.  The  government  or  Central  Bank  could  increase  
interest  rates  to  increase  the  value  of  the  Pound.  
• Improving  competitiveness.  The  government  could  use  deflationary  
fiscal  policy  to  reduce  inflation  and  improve  competitiveness.  It  could  also  
try  supply-­‐side  policies  to  improve  long-­‐run  competitiveness.  

Advantages  of  fixed  exchange  rates  

• Provide  greater  stability  for  firms  involved  in  trade,  e.g.  exporters  don’t  
have  to  fear  a  rapid  appreciation  which  would  reduce  their  profitability.  
• Can  help  reduce  inflation  as  countries  have  an  added  discipline  to  keep  
inflation  low,  otherwise  the  currency  would  be  weaker.  
• May  reduce  speculation  if  markets  believe  the  country  will  stick  to  an  
exchange  rate.  

97  
 
Disadvantages  of  fixed  exchange  rates  
• May  lead  to  the  exchange  rate  being  overvalued,  this  can  harm  exports  
and  economic  growth.  
• Maintaining  a  fixed  exchange  rate  may  require  high  interest  rates  (this  
may  conflict  with  other  objectives,  such  as  causing  lower  growth  and  
higher  unemployment).  
• UK  forced  out  of  ERM  in  1992,  because  markets  felt  they  had  joined  at  the  
wrong  rate.  Government  unable  to  maintain  value  of  Pound  in  ERM.  

Euro/  Monetary  union  

Joining  the  Euro  involves:  
1. Replacing  domestic  currency  with  Euros.  
2. No  possibility  of  fluctuating  exchange  rates  within  the  Euro  area.  
3. A  common  monetary  policy.  Interest  rates  are  set  by  the  ECB  for  the  
whole  Eurozone  area.  
4. Rules  about  size  of  budget  deficits  The  EU  Fiscal  stability  pact  includes  a  
rule  that  budget  deficits  should  not  exceed  3%  of  GDP  during  periods  of  
economic  growth.  (Essentially  a  structural  deficit  of  no  more  than  3%  of  
GDP.)  

Advantages  of  joining  the  Euro  

• Lower  transaction  costs.  If  the  UK  joined  the  Euro,  firms  and  tourists  
would  not  have  to  pay  the  cost  of  converting  currencies;  this  would  make  
trade  more  profitable.    Lower  costs  have  been  estimated  to  be  worth  1%  
of  GDP.  
• Eliminate  exchange  rate  fluctuations.  If  UK  exporters  experienced  a  
rising  Pound  Sterling  it  would  make  their  exports  less  competitive.  If  the  
exchange  rates  are  fixed,  firms  can  invest  in  export  capacity  with  more  
confidence  about  future  export  prices.    
• Increased  inward  investment.    With  stable  exchange  rates  and  the  
abolition  of  transaction  costs,  it  would  be  more  desirable  to  invest  in  the  
UK.  If  we  stay  out  of  the  Euro,  we  could  lose  out  on  this.  
• Greater  price  transparency.    With  a  common  currency,  it  is  easier  to  
compare  prices  in  different  EU  countries.  This  should  hopefully  lead  to  
greater  price  competition.    Also,  it  should  be  easier  for  firms  to  identify  
the  cheapest  suppliers.  
• Lower  inflation.  The  ECB  has  a  strong  tradition  of  keeping  inflation  low.  
Joining  the  Euro  would  help  reduce  inflation  expectations.  In  theory,  
joining  the  Euro  should  give  countries  an  incentive  to  remain  competitive  
and  increase  productivity,  because  they  cannot  rely  on  devaluation  to  
improve  competitiveness.  
 
 

98  
 
Problems  of  Euro/  Single  currency  
 
1.  Countries  will  lose  the  ability  to  set  interest  rates.    The  ECB  sets  interest  
rates  for  the  whole  Eurozone.  However,  this  may  not  be  suitable  for  the  UK  
economy.  
• For  example,  if  the  UK  was  in  a  deep  recession,  but  Europe  was  growing,  
the  ECB  would  set  a  high  interest  rate.  This  high  interest  rate  would  make  
it  difficult  for  the  UK  to  recover  and  grow  (e.g.  as  in  2008/09).  
• If  ECB  rates  were  too  low,  the  UK  may  experience  inflation.  
 
2.    Lack  of  exchange  rate  flexibility.  If  the  UK  joined  the  Euro  at  an  exchange  
rate  that  is  too  high,  it  would  make  UK  exports  uncompetitive,  because  it  is  
not  possible  to  devalue  the  exchange  rate.  
 
3.  Low  inflation  may  conflict  with  other  objectives.  It  is  argued  that  the  ECB  is  
too  concerned  with  low  inflation  and  ignores  other  macro-­‐economic  
objectives,  such  as  growth  and  unemployment.    Rates  of  economic  growth  
have  been  very  poor  (especially  in  Southern  Europe)  in  the  past  10  years.  
 
4.  Loss  of  independence  over  fiscal  policy.  The  growth  and  stability  pact  limits  
government  borrowing  to  no  more  than  3%  of  GDP,  but  trying  to  balance  the  
budget  in  a  recession  can  cause  a  further  fall  in  AD,  and  higher  
unemployment.      

Appreciation  in  the  exchange  rate  

An  appreciation  means  the  value  of  a  currency  increases.  The  effect  of  this  is:  

• Exports  more  expensive.  Therefore,  quantity  of  exports  falls.  

• Imports  cheaper.  Therefore,  quantity  of  imports  rises.  
• Lower  AD.  Assuming  demand  is  elastic,  an  appreciation  will  cause  lower  
aggregate  demand  and  lower  economic  growth.  
• Lower  inflation.  This  is  due  to  3  reasons:  
1. Lower  import  prices  e.g.  falling  oil  prices  from  the  appreciation.  
2. Lower  AD,  reducing  demand  pull  inflation.  
3. To  remain  competitive,  firms  have  an  incentive  to  cut  costs.  
• Worsening  of  current  account,  e.g.  bigger  deficit,  because  of  decline  in  
exports  and  rise  in  quantity  of  imports.  
• Foreign  direct  investment  may  fall.  A  rise  in  the  exchange  rate  may  
discourage  foreign  direct  investment  (FDI),  because  it  is  now  more  
expensive  for  foreign  firms  to  invest.  

Evaluation  of  an  appreciation  

• Depends  on  the  elasticity  of  demand  for  imports  and  exports.  The  
Marshall  Lerner  condition  (below)  states  an  appreciation  will  only  
worsen  current  account,  if  PEDX  +  PEDM  >1.  

99  
 
 • It  depends  on  other  components  of  AD.  An  appreciation  won’t  cause  a  
fall  in  AD,  if  consumer  spending  is  growing  strongly.  Consumer  spending  
is  a  bigger  component  of  AD  than  net  exports.  
• Time  lags.  Often,  demand  is  inelastic  in  the  short  term  and  becomes  more  
elastic  over  time.    Therefore,  an  appreciation  could  have  a  bigger  impact  
over  time.  
• It  depends  on  productivity  growth.  If  the  exchange  rate  appreciates  
because  firms  are  becoming  more  productive,  then  they  will  remain  
competitive.  If  the  exchange  rate  appreciates  due  to  speculation,  firms  are  
more  likely  to  become  uncompetitive.    
o For  example,  countries  like  Germany  and  Japan  have  prospered,  
even  in  periods  of  an  appreciating  currency.  
• It  depends  on  the  state  of  the  economy.  If  the  economy  is  growing  
strongly  and  is  near  full  capacity,  a  rise  in  the  exchange  rate  could  help  
reduce  inflationary  pressure  and  keep  growth  sustainable.  If  there  is  
already  spare  capacity,  then  an  appreciation  could  lead  to  a  recession.  

 
The  effects  of  an  appreciation  depend  on  the  state  of  the  economy.  A  fall  in  AD  to  
AD2  reduces  inflation,  with  little  effect  on  real  GDP.    But,  at  AD3  to  AD4,  there  is  
a  big  fall  in  real  GDP.  

Effects  of  a  depreciation  in  exchange  rate  

• Exports  cheaper  and  more  competitive  
• Imports  more  expensive  
• Increased  AD  and  higher  economic  growth  
• Inflation  may  rise  due  to  higher  import  prices  and  higher  AD.  
• Competitiveness  improves  in  the  short  term;  in  the  long  term  it  may  not  
improve  due  to  higher  inflation.  

100  
 
The  Marshall  Lerner  condition  
This  states  that  a  devaluation  will  improve  the  balance  on  the  current  account,  
on  the  condition  that  the  combined  elasticities  of  demand  for  imports  and  
exports  is  greater  than  one.  
• If  (PED  x  +  PED  m  >  1),  then  a  devaluation  will  improve  the  current  
account.  
• If  (PED  x  +  PED  m  >  1),  then  an  appreciation  will  worsen  the  current  
account.  
Essentially,  if  demand  for  exports  and  imports  is  elastic,  then  a  depreciation  will  
improve  the  current  account.  

The  J  Curve  effect  

In  the  short  term,  demand  for  imports  and  exports  tends  to  be  inelastic.  
Therefore,  after  a  devaluation,  the  current  account  can  get  worse  before  it  gets  
better.  However,  over  time,  demand  becomes  more  price  elastic  and  the  current  
account  improves.  

 
 
Initially  devaluation  worsens  current  account  because  demand  is  inelastic,  but  over  time  
demand  becomes  more  elastic  and  current  account  improves.  

101  
 
Economic  integration  
Trading  blocs.  A  trading  bloc  is  a  group  of  countries  who  agree  on  common  
rules  for  trade  and  tariffs.  It  may  also  involve  greater  economic  integration.  
Free  trade  areas.  Free  trade  areas  concentrate  on  free  trade  and  removing  tariff  
barriers,  e.g.  

• NAFTA  —  US,  Canada  and  Mexico  

• ASEAN  —  A  free  trade  area  based  in  South-­‐East  Asia  
Customs  union.  An  area  of  free  trade  with  a  common  external  tariff.  The  EEC  
was,  in  the  beginning,  a  customs  union.  

Single  European  market  -­‐  Economic  union.  The  EU  is  aiming  to  become  an  
area  of  close  economic  integration.  A  single  market  involves:  

• Free  trade  area  with  common  external  tariffs  

• Free  movement  of  labour  and  capital  
• Harmonisation  of  economic  laws  and  regulations,  e.g.  common  tax  rates  
• Cross-­‐border  economic  policies,  e.g.  EU  competition  and  agricultural  policy  
Monetary  union.  A  common  currency  (Euro)  and  common  monetary  policy  (e.g.  
for  the  whole  Eurozone).  

Benefits  of  EU  membership  

1. More  trade  and  gains  from  comparative  advantage.  For  the  UK  the  EU  is  
our  main  trading  partner  (roughly  60%  of  trade  with  EU).  
2. Greater  competition,  increasing  efficiency,  and  reducing  prices.  
3. Lower  costs  for  firms  to  have  common  rules  and  regulations,  e.g.  
acceptance  of  educational  qualifications.  
4. Increased  direct  investment,  which  helps  promote  better  efficiency.  
5. Greater  clout  for  international  trade  negotiations.  
6. Countries  may  benefit  from  more  flexible  labour  markets,  as  workers  can  
migrate  to  fill  labour  shortages,  e.g.  UK  benefited  from  Eastern  European  
workers  filling  in  vacancies  in  the  service  sector.  
7. By  staying  out  of  the  Eurozone,  the  UK  has  avoided  problems  of  single  
currency  and  common  monetary  policy.  

Evaluation  of  EU  membership  

• Free  movement  of  labour  can  cause  friction  and  concerns  about  over-­‐
population  and  demands  on  housing.  
• Countries  with  large  agricultural  sectors  tend  to  benefit  from  large  
agricultural  subsidies.  
• Countries  in  south,  e.g.  Greece,  Spain  and  Italy,  have  struggled  to  cope  
with  Euro  and  common  monetary  policy.  
• Some  fear  EU  makes  it  more  difficult  to  reach  consensus  because  of  the  
large  number  of  countries.  

102  
 
 The  financial  sector  
 

Characteristics  of  money  

• Medium  of  exchange  (widely  accepted  in  society)  
• Store  of  value  
• Deferred  payment  
• Unit  of  account  
Money  allows  individuals  to  make  transactions  and  specialise  in  particular  jobs.  
Money  supply.  This  measures  the  total  amount  of  money  in  the  economy.  The  
money  supply  includes  cash  (notes  and  coins),  but  also  bank  deposits  (deposits  
that  can  easily  be  withdrawn  and  converted  into  spending  cash  or  used  by  debit  
cards).  
1. Narrow  money.  This  definition  of  money  just  includes  the  level  of  notes  
and  coins  in  circulation.  For  example  M0  =  the  level  of  notes  and  coins  in  
circulation  +  banks’  operational  balances  at  the  Bank  of  England.  
2. Broad  money.  This  includes  notes  and  coins  in  circulation  +  private  
sector  deposits  in  banks  and  building  societies.  For  example  M4.  This  
figure  is  much  higher  than  M0.  

 
 

103  
 
The  graph  shows  

• M0  =  Narrow  money  supply  

• CPI  =  Inflation  rate  
• M4  =  Broad  money  

Interest  rates  
• Interest  rates  set  the  cost  of  borrowing  money.  Interest  rates  also  reflect  
the  rate  of  return  from  saving.  
• Real  interest  rates  =  nominal  interest  rates  –  inflation  rate.  For  example,  if  
the  Central  Bank  set  base  interest  rate  at  5%,  and  inflation  is  3%,  the  real  
interest  rate  is  2%.  

Liquidity  preference  theory    

• This  shows  the  demand  for  money  that  occurs  at  different  interest  rates.  
• It  was  developed  by  Keynes  who  argued  that  people  kept  money  for  
different  reasons  –  the  transaction  motive,  precautionary  motive  and  
speculative  motive  (saving  money  as  an  alternative  to  holding  bonds).  
• At  lower  interest  rates,  people  have  more  demand  for  money  because  it  is  
not  profitable  to  buy  bonds  (which  give  low  return).    
• At  higher  interest  rates,  people  have  less  demand  for  money  because  it  is  
more  profitable  to  hold  bonds.  

 
This  suggests  that  an  increase  in  the  supply  of  money  should  reduce  interest  rates.  

104  
 
Loanable  funds  theory  
This  states  that  interest  rates  are  determined  by  the  interaction  of  supply  and  
demand  of  loanable  funds.  

• Supply  of  loanable  funds  comes  from  saving.  

• Demand  for  loanable  funds  comes  from  individuals  wishing  to  borrow  for  
purposes  of  spending  or  investment.  

 
An  increase  in  savings  would  shift  S  to  the  right  and  reduce  interest  rates  

Interest  rates  and  inflation  

Typically  nominal  interest  rates  may  be  1  or  2%  points  higher  than  inflation.  If  
inflation  increases,  the  Central  Bank  tends  to  increase  interest  rates  too:  

• Higher  interest  rates  to  reduce  the  inflationary  pressures.  

• Increasing  interest  rates  also  maintains  positive  real  interest  rates,  so  
savers  don’t  lose  money.  

Different  types  of  interest  rate  

In  an  economy,  there  are  several  different  types  of  interest  rates.  Generally  
riskier  borrowing  will  lead  to  higher  interest  rates  to  compensate  for  risk  of  
bank  losing  loan.  

 
 

105  
 
Examples  of  different  loans  

• Mortgages  are  secured  against  value  of  house.  Loan  can  extend  to  40  
years,  they  tend  to  have  lower  interest  rates,  e.g.  perhaps  5%.  
• Unsecured  personal  loans  are  loans  for  purchase  of  items  like  cars.  
Typical  interest  rate  may  be  7%.  
• Credit  cards.  Debt  on  credit  cards  which  is  not  paid  off  at  the  end  of  the  
month  can  attract  high  interest  rates  of  15-­‐18%.  
• Pay  day  loans.  These  are  aimed  at  people  without  access  to  bank  
accounts  or  the  usual  types  of  credit.  They  maybe  short  term  loans  for  a  
few  days  or  weeks  until  pay  day.  They  can  have  very  high  annual  rates  of  
interest  rates  (1,000%).  

Financial  markets    
• Stock  markets.  Enabling  the  buying  and  selling  of  shares  on  listed  stock  
markets.  Firms  can  use  stock  markets  to  issue  more  shares  and  raise  
finance.  
• Bond  markets.  This  involves  buying  and  selling  government  bonds  to  
fund  public  sector  borrowing.  Besides  government  bonds,  there  are  also  
private  sector  bond  markets  for  firms.  
• Commercial  banking.  Offering  firms  the  chance  to  save  and  borrow  for  
investment.  
• Personal  banking.  Offering  individuals  the  opportunity  to  save  and  
borrow.  
• Money  markets.  A  wide  range  of  financial  markets  which  enable  banks  
and  companies  to  borrow  and  lend  for  the  short  term.  
• Inter-­‐bank  lending.  Banks  often  need  to  borrow  from  other  financial  
institutions  to  meet  short-­‐term  liquidity  requirements.    
• Foreign  exchange  markets.  Where  individuals  and  firms  can  buy  and  
sell  foreign  exchange  reserves.  
• Pension  funds.  Investing  on  behalf  of  workers  who  saving  for  retirement.  
Reduces  risk  for  workers  with  limited  knowledge  of  financial  markets.  

Role  of  financial  markets  

• Saving.  Banks  and  building  societies  offer  consumers  and  firms  a  place  to  
save  and  gain  interest  on  savings.  Consumers  can  also  save  through  
buying  bonds  and  other  investment  funds.  
• Lending.  Financial  markets  are  critical  to  enable  borrowing  by  firms  and  
consumers.  This  enables  firms  to  borrow  to  fund  investment,  and  enable  
higher  economic  growth.  
• Reducing  risk.  Financial  markets  can  be  used  to  insure  against  
unexpected  losses/risk.    
• Forward  market  in  commodities.  This  means  that  firms  can  agree  to  
buy  commodities  at  certain  prices  in  the  future.  It  offers  a  way  to  ‘hedge’  
(insure)  against  the  risk  of  fluctuating  prices.  For  example,  a  forward  
market  enables  a  firm  to  buy  oil  at  an  agreed  price  in  the  future.  

106  
 
 • Shares.  Firms  list  their  company  on  the  stock  market  so  that  they  can  
raise  money  from  shareholders.  This  can  be  beneficial  for  raising  finance  
for  long-­‐term  investment.  Shareholders  are  often  willing  to  take  more  of  a  
risk  than  a  bank,  e.g.  the  Eurotunnel  was  financed  by  selling  shares  to  
investors.  

Importance  of  financial  markets  for  wider  economy  

• Enable  firms  to  borrow  for  investment.  
• Enable  the  government  to  borrow  to  invest  and  meet  shortfalls  in  tax  
revenue.  
• Enable  firms  to  reduce  risk  and  uncertainty,  e.g.  reduce  fluctuations  in  the  
exchange  rate  to  encourage  more  trade  and  investment.  
• Enable  firms  to  survive  economic  downturns  by  borrowing  from  banks  or  
issuing  shares  in  difficult  times.  
• Enable  firms  and  consumers  to  make  productive  use  of  savings.  
 

Bank  (cash)  reserve  ratio  

• This  is  the  percentage  of  customer  deposits  that  are  kept  in  cash  reserves  
(and  not  lent  out  on  more  profitable  loans).  
• Central  Banks  usually  set  a  minimum  reserve  ratio  that  commercial  banks  
must  keep,  so  that  banks  have  enough  cash  to  meet  withdrawal  requests.  

How  banks  create  credit/money  multiplier  

• The  banking  system  enables  banks  to  create  credit  and  increase  the  
money  supply.  
• If  a  bank  received  deposits  of  £1  million,  the  bank  may  lend  out  90%,  
creating  £0.9  million  of  loans.  
• In  turn,  this  loan  may  be  deposited  back  in  the  banking  system.  
• With  an  increase  in  the  number  of  money  lent  out,  the  money  supply  
increases  and  the  banks  will  eventually  receive  another  £0.9  million  in  
deposits.  
• With  more  deposits,  the  process  of  lending  a  certain  percentage  can  start  
again.    
 
Money  multiplier  =  1/R  

• R  =  reserve  ratio  (e.g.  10%)  

• If  the  reserve  ratio  is  10%,  then  the  multiplier  will  be  1/0.1  =  10  
• Therefore,  with  a  reserve  ratio  of  10%,  the  money  multiplier  would  cause  
the  initial  £1  million  to  increase  to  £10  million.  

107  
 
 Financial  sector  in  developing  economies  
 
Financial  capital  is  a  major  factor  in  enabling  higher  economic  growth.  This  
could  be  loans  which  enable  investment  or  foreign  aid.  
Remittances.  This  is  when  foreign  workers  send  money  back  to  their  country  of  
origin.  For  example,  workers  from  Nepal  may  move  to  the  Middle  East  and  send  
money  earned  back  home  to  their  family.  This  foreign  exchange  can  increase  net  
wealth  of  developing  countries  and  enable  higher  living  standards.    
Direct  foreign  investment.  Foreign  investment  by  multinationals  or  Non-­‐
governmental  organisations  (NGO’s)  could  involve  increasing  infrastructure  
investment  or  building  new  factories.  

Harod  Domar  model  suggests  that  economic  growth  rates  depend  on  two  
things:  

• Level  of  savings  (higher  savings  enable  higher  investment)  

• Capital  Output  Ratio  (efficiency  of  investment)  
In  developing  countries  with  low  levels  of  savings,  aid,  or  interest  free  loans  can  
help  increase  levels  of  investment  and  therefore  development.  
Also,  if  governments  can  increase  level  of  savings  and  improve  strength  of  
financial  system,  this  will  help  development.    

Microfinance.  This  is  a  project  to  help  people  on  very  low  incomes  to  gain  access  
to  credit  to  start  small-­‐scale  projects.  Micro-­‐finance  is  not  aid,  but  a  self-­‐
financing  scheme  where  people  will  pay  back  loans,  but  at  low  interest  rates,  
projects  and  avoid  the  excessive  interest  rates  of  moneylenders.  

• Depends  on  how  it  is  managed  and  directed.  Finance  could  be  misused,  
though  default  rates  are  generally  low.  

Evaluation  of  financial  sector  in  developing  economies  

• Debt  interest  payments.  Many  developed  countries  have  struggled  to  
keep  up  with  high  debt  interest  payments  from  previous  loans  (both  
public  and  private  sector).  These  debt  interest  payments  can  take  up  
important  foreign  exchange  reserves.  Debt  relief  has  been  a  major  plank  
of  foreign  aid  and  policy  to  help  development.  
• Microfinance  can  play  a  role  in  extending  financial  markets  to  poor  people  
(often  women)  who  previously  missed  out  from  lack  of  access  to  finance,  
but  it  can  only  do  so  much.  Large  scale  infrastructure  and  education  
would  require  government  intervention.  
• Remittances  are  a  good  source  of  foreign  currency,  but  the  downside  is  
that  the  best  young  and  able  workers  are  leaving  the  developing  countries  
thus  creating  a  brain  drain  and  this  can  hamper  development.  

108  
 
 The  role  of  the  central  bank  
Central  Banks  play  an  important  role  in  a  modern  economy.  Their  functions  
include:  

1. Monetary  policy.  Central  Banks  are  usually  responsible  for  monetary  

policy.  This  involves  changing  interest  rates  to  meet  the  government’s  
target  for  inflation  (and  other  macro-­‐objectives).  
2. Banker  to  the  government.  Central  Banks  manage  the  government’s  
financial  account.  
3. Lender  of  last  resort.  An  important  role  is  acting  as  the  lender  of  last  
resort,  for  both  the  government  and  private  banks.  If  the  government  
runs  out  of  money,  the  Central  Banks  can  step  in  to  buy  government  debt,  
preventing  panic  about  the  government’s  liquidity.  They  can  also  lend  
money  to  commercial  banks  if  they  are  temporarily  short  of  liquidity  
(money).  
4. Printing  money.  The  Central  Bank  is  often  responsible  for  managing  the  
money  supply;  this  involves  printing  new  money  and  possibly  
quantitative  easing  (creating  money  electronically).  
5. Regulation  of  the  banking  industry.  With  other  financial  watchdogs,  
Central  Banks  can  be  responsible  for  regulating  the  financial  sector.  This  
can  involve  setting  reserve  ratios  and  preventing  financial  market  rigging.  

Independent  central  bank  

• An  independent  Central  Bank  has  the  autonomy  to  make  decisions  on  
monetary  policy  without  government  interference.    
• For  example,  the  Bank  of  England  is  independent,  though  it  does  have  to  
try  and  meet  the  government’s  target  on  inflation.  
• A  Central  Bank  under  government  control  will  mean  the  government  can  
decide  interest  rates  and  the  money  supply,  which  may  make  inflation  
more  likely.  

Objectives  of  central  bank  

1. Primary  objective  –  low  inflation  
2. Secondary  objective  –  other  macroeconomic  objectives  such  as  economic  
growth  and  unemployment.  

Advantages  of  central  bank  targeting  macro-­‐economic  

indicators  
• Central  Bank  is  not  swayed  by  political  pressure,  e.g.  it  will  not  cut  
interest  rates  before  an  election.  
• Expectations.  People  may  have  more  confidence  in  an  independent  
Central  Bank  to  keep  inflation  low  and  this  may  help  reduce  inflation  
expectations,  which  in  turn  helps  keep  inflation  low.  

109  
 
 • Low  inflation  is  considered  to  be  the  most  important  building  block  of  a  
modern  economy  

Disadvantages  of  central  bank  targeting  macro-­‐economic  

indicators  
• Inflexibility.  With  an  inflation  target,  the  Central  Bank  may  place  too  much  
emphasis  on  reducing  inflation  and  ignore  more  pressing  problems,  such  
as  unemployment  and  growth.  
• Cost-­‐push  inflation.  In  2008,  economies  experienced  cost-­‐push  inflation  
and  a  recession  at  the  same  time.  The  ECB  increased  interest  rates  but  
this  made  Eurozone  recession  worse.  
• Inflation  not  always  highest  priority.  Arguably  unemployment  of  10-­‐20%  
we  see  in  Eurozone  is  more  damaging  than  inflation  of  3-­‐4%,  but  ECB  
retains  low  inflation  as  a  primary  objective.  

Lender  of  last  resort  

• One  role  for  the  Central  Bank  is  to  act  as  the  lender  of  last  resort.  This  
means  that  if  banks  are  short  of  cash,  the  central  bank  will  step  in  and  
provide  cash  /  liquidity.  
• This  gives  people  confidence  in  the  banking  system  and  prevents  bank  
panics,  where  people  try  to  withdraw  their  money.  
• The  disadvantage  is  that  it  can  create  moral  hazard.  It  can  encourage  
banks  to  take  risks,  because  if  things  go  badly,  the  Central  Bank  will  bail  
them  out.  
 

Regulation  of  the  financial  system  

The  need  for  regulation  
• Asymmetric  information.  Financial  bodies  may  not  be  aware  of  the  real  
state  of  a  company’s  increasing  likelihood  of  debt  default.    
• A  problem  in  the  credit  crunch  was  that  many  banks  bought  bundles  
of  US  mortgage  debt,  not  realising  that  many  US  mortgages  were  
highly  likely  to  default.  
• Moral  hazard.  Moral  hazard  occurs  when  financial  guarantees  alter  
economic  behaviour  and  increase  risk-­‐taking.    
• A  Central  Bank  commits  to  guaranteeing  all  bank  deposits.  If  a  
commercial  bank  goes  bankrupt,  the  Central  Bank  will  bail  it  out.    
• Arguably,  this  bailout  guarantee  encourages  commercial  banks  to  take  
more  risks  because,  if  they  lose  money,  the  Central  Bank  will  step  in.    

110  
 
• Speculation  and  market  bubbles.  In  the  finance  sector,  we  often  see  
‘market  bubbles’  due  to  speculation  and  over-­‐confidence.    
o If  an  asset  (such  as  housing)  rises  in  price,  people  think  this  is  a  very  
good  investment  and  so  buy  to  try  and  benefit  from  rising  house  
prices.  Due  to  over-­‐confidence,  the  price  of  the  asset  can  become  
inflated  above  its  true  value.    
o Later,  prices  can  fall  significantly  as  the  asset  returns  to  its  true  value.  

Irish  house  prices  rose  30%  in  just  two  years,  but  fell  35%  when  the  housing  bubble  ended.  

• Market  rigging.  This  occurs  where  those  with  inside  knowledge  are  able  
to  manipulate  financial  markets.    
• For  example,  traders  may  try  to  fix  interest  rates  so  that  they  can  
make  more  profit,  e.g.  the  Libor  scandal  with  commercial  banks  guilty  
of  fixing  inter-­‐bank  lending  rate.    
•    Systemic  risk.  This  occurs  when  problems  at  one  bank  put  the  whole  
financial  system  at  risk.  For  example,  if  one  bank  went  bust,  it  would  
cause  a  loss  of  confidence,  and  customers  would  try  to  withdraw  their  
money,  causing  a  panic.  
• Banking  failures  can  be  contagious.  If  one  bank  goes  bankrupt,  the  
whole  banking  system  will  be  negatively  affected.  

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How  financial  institutions  can  be  regulated  
1.  Set  liquidity  ratio  

The  liquidity  ratio  is  the  ratio  of  short-­‐term  assets  which  can  be  used  to  pay  
short-­‐term  debts.  It  is,  essentially,  the  level  of  cash  (or  cash  equivalent)  to  debt.  

• A  higher  liquidity  ratio  makes  a  bank  have  more  cash  reserves  to  be  
able  to  in  meet  debt  requirements.  
2.  Set  capital  ratio  (CAR).  This  is  similar  to  liquidity  ratio.  It  is  the  ratio  of  its  
bank  capital  to  the  risk  of  its  assets.  It  places  a  weighting  on  the  risk  of  different  
assets.  

• A  high  capital  adequacy  ratio  means  that  a  bank  has  a  higher  level  of  
reserves  to  meet  any  potential  risk  from  default  on  loans.  
3.  Financial  Policy  Committee  (FPC)  at  the  Bank  of  England.    The  objective  of  
the  FPC  is  to  remove  or  reduce  systemic  risks  in  the  financial  system.    The  FPC  
can:  

• Examine  levels  of  debt  or  credit  growth,  and  require  banks  to  take  less  
risk.  
• Examine  potential  risks  in  the  financial  system.      
• Examine  levels  of  cash  reserves  (capitalization).  
• Warn  MPC  Bank  of  England  if  monetary  policy  poses  risk  to  financial  
stability.  
Functions  of  FPC  

• Warning  banks  of  potential  risks.    

• Setting  levels  of  capital  buffers.  The  FPC  can  make  banks  hold  more  cash  
during  a  boom.  This  enables  a  bank  to  better  survive  a  downturn.  
• Setting  sectoral  capital  requirements.  This  involves  setting  levels  of  
exposure  to  particular  sectors,  e.g.  reducing  a  bank’s  reliance  on  variable  
mortgages.  
4.  Prudential  Regulation  Authority  PRA.  Overseas  financial  bodies  taking  large  
risks,  such  as  insurance.  
5.  Financial  Conduct  Authority  FCA  was  set  up  to  protect  consumers  from  
misleading  information  or  unsuitable  financial  products/services.    
6.  IMF  and  World  Bank  attempt  to  give  oversight  to  aspects  of  global  financial  
system  and  warn  banks  of  excessive  risks.  
 
 

 
 

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Evaluation  of  financial  regulation  

• It  may  be  difficult  to  predict  how  much  capital  buffers  are  required.  
• Banks  can  often  find  ways  around  government  regulation  by  devising  new  
complex  instruments  and  derivatives.  
• Raising  capital  reserves  could  lead  to  lower  lending  and  investment,  
leading  to  lower  growth.  
• It  is  easy  to  be  wise  after  the  event.  Very  few  saw  the  financial  crisis  of  
2008/09  coming.  Though  many  bank  regulations  were  removed  in  the  
1980s  and  1990s,  making  it  easier  for  banks  to  reduce  capital  reserves  
and  take  out  more  risky  loans.  
• The  IMF  and  World  Bank  have  very  limited  ability  to  regulate  global  
financial  markets  because  they  have  limited  power  and  it  is  hard  to  keep  
track  of  global  finances.  
 

Impact  of  financial  risk  on  the  wider  economy  

• Confidence.  Events  in  financial  markets  can  affect  businesses  and  
consumer  confidence.  If  there  is  a  serious  fall  in  the  stock  market  or  bond  
market,  the  negative  news  may  reduce  consumer  and  business  confidence,  
leading  to  lower  spending  and  investment.  
 
• Access  to  credit  affects  consumers.  If  banks  are  reluctant  to  lend,  
consumers  will  find  it  more  difficult  to  finance  consumer  spending  and  
buy  a  house.  This  can  lead  to  lower  consumer  spending  and  lower  
economic  growth.  
 
• Access  to  credit  affects  investment.  Businesses  rely  on  credit  and  loans  
to  finance  investment.  Without  access  to  sufficient  loans,  it  will  lead  to  
lower  investment  and  curtail  economic  growth.  
 
• Global  nature  of  financial  markets.  Crisis  in  global  financial  markets  
tends  to  spill  over  to  all  major  economies,  affecting  growth  in  other  
countries.  Therefore,  a  financial  crisis  will  affect  UK  exports.  Also,  the  UK  
is  more  dependent  on  financial  markets  than  other  countries  for  service  
sector  earnings.  
 
• Lower  pension  funds.  Many  people  do  not  hold  shares  directly,  but  
indirectly  through  pension  investments.  Therefore,  a  prolonged  fall  in  
share  prices  and  bond  prices  can  lead  to  lower  pension  funds  and  lower  
pension  payments.  This  will  reduce  consumer  spending.  
 
 

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